When the music stops

Right now, there’s an ongoing debate about the Fed’s tightening cycle: will it resolve itself into a soft landing with the economy on sound footing, or as a hard landing with all the accompanying discord of a recession? Likely, this debate will play out for many months but regardless of the outcome, one thing is all but certain: interest rates will be coming down and probably sooner rather than later. 

For investors, this creates a dilemma. Ever since the Fed funds rate peaked at the 5.5% upper bound, capital has flowed into money markets thanks to high real returns and their potential to buffer portfolio volatility. But as the Fed changes its tune, many investors will now be looking to reassess their portfolios and redeploy their assets – including excess cash – into new territory.

A change in tempo

Given this backdrop and the very real likelihood of rate cuts, one thing we might ask ourselves is whether the time is now right for investors to reconsider the case for alternatives.

We think this could make sense for investors able to tolerate higher risk and volatility, for multiple reasons. For one thing, alternatives cover a wide swath of strategies. And while their potential to combine lower correlations with strong return potential is attractive, they remain outside the mainstream for many investors. Alternative strategies can carry with them additional risks not found with traditional equity, fixed income and money market approaches. But investors seeking to manage risk at the portfolio level may find the diversification potential and scope for uncorrelated returns found in alternatives worth any potential risk at the strategy level.

Take one alternatives approach as an example: an equity market-neutral strategy. Here, instead of following popular benchmark indexes, a manager will typically rely on fundamental and/or technical security selection to pursue their goals. In simple terms, a market-neutral manager might seek to buy stocks they think could outperform (long positions) and sell borrowed stocks they believe may underperform (short positions). That means the potential risk and returns of this strategy tends to be predicated less on the general direction of the markets and more on the performance and positioning of their chosen securities. In short, it’s not the market direction but the underlying securities and how they perform that matters. 

Historically, this kind of approach has produced relatively low correlations to stocks and bonds and had even lower correlations during the dot.com bust and the global financial crisis. In fact, during the dot.com bust, equity market neutral strategies had a negative correlation. In other words, equity market-neutral strategies did what they were supposed to when it mattered most.

What’s surprising, though, is that private wealth investors appear not to have taken heed of this alternatives message: While institutional clients have long made use of alternative strategies, Morningstar data suggests that less than 1% of total mutual fund assets are in alternatives. 

Perhaps it’s time for that to change. Investors might feel they only need alternatives when stocks are performing poorly, but we believe they can be both a source of long-term total return and an important component of portfolio volatility management. 

At the end of the day, nobody knows if the landing will be hard or soft this time or next or how markets will respond. What we can say is that, with its scope for providing uncorrelated, long-term rates of return, an allocation to alternatives could offer the appropriate coda to this latest era of elevated rates.