My last four blogs have defined alternative investments, explained why I believe investors should consider them, discussed performance expectations and outlined how to deploy alternatives in a portfolio. In this final installment of my series, I will apply these lessons to the current volatile market environment and discuss which alternatives may be able to help in various scenarios.
Below, I’ve listed several common investor portfolio objectives. While there are no guarantees that performance will meet expectations, each objective is paired with an alternative strategy that may help investors meet specific goals.
Objective: Boost performance in low-return, more volatile equity environments
Consider: Alternative asset and global macro funds
Alternative assets (also known as real assets) are investments in asset classes other than stocks and bonds. Real estate, commodities, natural resources, infrastructure and master limited partnerships (MLPs) are all examples of assets that can be used in an inflation hedging strategy. These investments have unique performance characteristics relative to equities, and collectively have outperformed equities for nearly 20 years. Global macro funds can also be deployed as a portfolio diversification strategy. These funds can invest on a long or short basis into many asset markets, and as the data show below, it is possible to generate positive long-term returns with less risk as measured by standard deviation and maximum decline. See the table below for examples of historical performance.
Performance of various alternative strategies from Sept. 1, 2001 through June 30, 2018
Source: StyleAdvisor. September 2001 to June 2018. Maximum decline refers to the largest percentage drop in performance. Equities are represented by the S&P 500 Index. Fixed income is represented by the Barclays U.S. Aggregate Bond Index. Inflation hedging is represented by 75% FTSE NAREIT US Real Estate Index Series, All Equity REITs and 25% Bloomberg Commodity Index. The 75%/25% split reflects Invesco’s belief that investors tend to invest in strategies with which they are more familiar. Principal preservation is represented by the BarclayHedge Equity Market Neutral Index. Portfolio diversification is represented by 60% BarclayHedge Global Macro Index and 40% BarclayHedge Multi Strategy Index. Multi strategy is underweighted in this example due to its potential overlap with global macro. Equity diversification is represented by the BarclayHedge Long/Short Index. Fixed income diversification is represented by equal allocations to BarclayHedge Fixed Income Arbitrage Index and S&P/LSTA US Leveraged Loan Index.
Because of the flexibility granted to global macro portfolio managers, these funds have the potential to achieve profits in both rising and falling market environments. While they may outperform equities during these periods, these funds can also underperform.
Objective: Principal preservation
Consider: A market neutral strategy
Market neutral funds trade related equities with the goal of profiting from both increasing and decreasing prices. Because these portfolio managers can invest on a long and short basis, their goal is to generally have close to zero net market exposure (the percentage difference between the long and short exposures in zero). With a market neutral strategy, the key to generating a positive return is security selection — determining which equities to go long and which to go short. Given the typical lack of net market exposure, these strategies may help reduce volatility from market swings, can potentially generate positive returns in all market environments, and typically have a low correlation to stocks and bonds. Please see the table above for historical performance of a principal preservation strategy.
Objective: Fixed income diversification (try to lessen the impact of rising interest rates)
Consider: Senior loans and market-neutral funds
Senior loans (also known as bank loans) are typically made by banks to non-investment grade companies, commonly in relation to leveraged buyouts, mergers and acquisitions. The loans are called “senior” because they are contractually senior to other debt and equity, and are usually secured by collateral. Because these loans are often made to non-investment grade companies, the yield tends to be higher than on investment grade corporate bonds. Another key aspect of senior loans is that the interest rate paid is often floating with a 30- to 90-day reset. This means that in a rising interest rate environment, the investor may benefit by receiving increasing payments from the borrower. Please see the table above for historical performance of a fixed income diversification strategy.
Objective: Inflation hedge
Consider: Certain alternative assets
Real estate, commodities, leveraged loans and MLPs have historically increased in value during periods of inflation, and for this reason, can potentially help a portfolio during these events. As an example, commodities have historically demonstrated among the highest correlations to the consumer price index versus other asset classes.1 This behavior is generally attributed to the desire of investors to own physical (or easy to understand) assets during times of market turmoil. Please see the table above for historical performance of an inflation hedging strategy.
Objective: Equity diversification (benefit from rising equities with downside protection)
Consider: Long/short equity strategy
These combine both long and short equity positions in a portfolio, while typically being net long to equities. A long/short strategy can be used with equities or fixed income with the goal of benefitting from rising prices on the long side and declining prices on the short side. Since a long/short portfolio is more heavily weighted to the long side, performance would tend to follow (for example) the equity market, but with a caveat — the short positions have the potential to cushion performance during periods of market decline. Please see the table above for historical performance of an equity diversification strategy.
Objective: Fixed income diversification (try to boost current income)
Consider: Senior loans and income-generating real assets
For the reasons mentioned earlier, senior loans tend to produce attractive yield for investors, generally exceeding that of investment grade bonds. For example, the yield of the S&P/LSTA US Leveraged Loan 100 B/BB Rating Index was 5.19% as of July 31, 2018, compared to 3.91% for the S&P 500 Industrials Corporate Bond Index.2 Income-producing real asset investments such as infrastructure and MLPs have the potential to deliver levels of current income above that of government and investment grade corporate bonds (Click here for additional information on infrastructure and MLP investments). Please see the table above for historical performance of a fixed income diversification strategy.
Key takeaway
One final word on alternatives: The most common mistake I see investors make is investing on a reactive basis (in other words, investing in alternatives only after they’ve performed well). In my view, the time to explore the possible benefits of alternatives is before they are needed, especially is a volatile market environment.
I hope everyone has had a great summer and has found this blog series helpful. Learn more about Invesco and our alternative capabilities.
Past performance is not indicative of future results. Investments cannot be made directly into an index.
1 Source: Bloomberg L.P., Dec. 31, 2002, through Dec. 31, 2017.
2 Source: S&P Dow Jones
Important information
Blog header image: Ioan Panaite/Shutterstock.com
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
The FTSE NAREIT All Equity REIT Index is an unmanaged index considered representative of US REITs.
The Bloomberg Commodity Index is a broadly diversified commodity price index.
The Bloomberg Commodity Index is a broadly diversified commodity price index.
The BarclayHedge Equity Market Neutral Index includes funds that attempt to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country.
The BarclayHedge Global Macro Index includes funds that carry long and short positions in any of the world’s major capital or derivative markets.
The BarclayHedge Multi-Strategy Index includes funds that are characterized by their ability to dynamically allocate capital among strategies falling within several traditional hedge fund disciplines.
The BarclayHedge Long/Short Index includes funds that employ a directional strategy involving equity-oriented investing on both the long and short sides of the market.
The BofA Merrill Lynch US Inflation-Linked Treasury Index is an unmanaged index comprised of US Treasury Inflation-Protected Securities with at least $1 billion in outstanding face value and a remaining term to final maturity of greater than one year.
The DBIQ Optimum Yield Diversified Commodity Index Excess Return is a rules-based index composed of futures contracts on 14 of the most heavily-traded and important physical commodities in the world.
The MSCI EAFE Index is an unmanaged index designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
The MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developing countries.
The MSCI US REIT Index is a free-float-adjusted, market capitalization index that is composed of equity REITs.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
COMEX is the primary futures and options market for trading metals such as gold, silver, copper and aluminum. Formerly known as the Commodity Exchange Inc., COMEX merged with the New York Mercantile Exchange in 1994 and became the division responsible for metals trading.
The consumer price index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices.
Stocks are related if driven by the same fundamental factors. For example, two stocks from the same industry would be related.
A master limited partnership (MLP) is a publicly traded limited partnership in which the limited partner provides capital and receives periodic income distributions from the MLP's cash flow and the general partner manages the MLP's affairs and receives compensation linked to its performance.
Long/short equity strategies involve taking long positions in stocks that are expected to increase in value while taking short positions in securities that are expected to decrease in value. Long/short equity strategies generally seek to minimize net market exposure to benefit from rising prices on the long side and declining prices on the short side.
Long positions are buying a security with the expectation that it will increase in value.
Short positions/short selling is the sale of a security not owned by the seller, then buying later. The belief is that security prices will decline and the price paid to buy it back at will be lower than the price it was sold.
Long/short strategies (equity or credit) typically take both long and short positions to benefit from rising prices on the long side and declining prices on the short side.
Maximum decline refers to the largest percentage drop in value during the measured period.
Net market exposure is the percentage difference between a funds’s long and short exposure.
Standard deviation measures a portfolio’s or index’s range of total returns in comparison to the mean.
Correlation is the degree to which two investments have historically moved in relation to each other.
Diversification does not guarantee a profit or eliminate the risk of loss.
Most senior loans are made to corporations with below-investment grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid.
Most master limited partnerships (MLPs) operate in the energy sector and are subject to the risks generally applicable to companies in that sector, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk. MLPs are also subject to the risk that regulatory or legislative changes could eliminate the tax benefits enjoyed by MLPs, which could have a negative impact on the after-tax income available for distribution by the MLPs and/or the value of the portfolio’s investments.
Although the characteristics of MLPs closely resemble a traditional limited partnership, a major difference is that MLPs may trade on a public exchange or in the over-the-counter market. Although this provides a certain amount of liquidity, MLP interests may be less liquid and subject to more abrupt or erratic price movements than conventional publicly traded securities. The risks of investing in an MLP are similar to those of investing in a partnership and include more flexible governance structures, which could result in less protection for investors than investments in a corporation. MLPs are generally considered interest-rate-sensitive investments. During periods of interest rate volatility, these investments may not provide attractive returns.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
Short selling is a speculative investment and may require investors to meet margin requirements and repurchase the security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, loss potential is unlimited.
Alternative investments can be less liquid and more volatile than traditional investments such as stocks and bonds, and often lack longer-term track records.
Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Walter Davis
Alternatives Investment Strategist
As Alternatives Investment Strategist, Walter Davis serves as Invesco’s primary alternatives representative to retail, high net worth and institutional clients across the major broker dealers, wirehouses and RIAs. He is responsible for collaborating across Invesco’s alternative strategies to develop a cohesive alternatives education program for financial advisors and investors.
Prior to joining Invesco in 2014, Mr. Davis served as a managing director in Morgan Stanley’s Alternative Investments Department, and earlier as director of High Net Worth and Institutional Sales. Prior to Morgan Stanley, he worked at Chase Manhattan Bank in the Alternative Investments Department. He has worked in the industry since 1991.
Mr. Davis graduated cum laude with a BA in economics from the University of the South. He earned an MBA in finance and international business from Columbia Business School. He holds the Series 3, 7, 24 and 63 registrations.
Before investing, carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the products, visit invesco.com/fundprospectus for a prospectus/summary prospectus.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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