There is a well-known adage in investing that investors often sell what they are just about to need. The idea around it is simple, which is that the market often works in cycles and trends. Something in favor today may be out of favor tomorrow.
An investor may initially like a holding and feel compelled to keep it, but that position continues to underperform. Right about the time the investor submits and sells the position, the investment goes ahead and outperforms. As a new year commences, it feels like a similar environment exists for alternative investment strategies.
The term alternative can represent a lot of different strategy types. Typically, an alternative will be a strategy that shorts securities, as part of a dedicated short strategy or as part as part of a long-short strategy. A good benchmark for this alternative strategy category is the HFRI Equity Hedge (Total) Index. However, do not be fooled by its index label. This index is an aggregate of private fund managers who engage in a variety of investment strategies but who, at a minimum, short an average 50% of their portfolio. To understand why there are so many stories about alternatives not working, look no further than the index's most recent performance (see Figure 1).
One can see how even after suffering the drawdowns of 2007 and 2008, memories fade. Investors may feel like they are missing the stock market's most recent ride, but remembering those trying times is important.
Mark Twain is credited with saying, “history doesn't always repeat itself but it often rhymes,” which can also apply to the financial markets, as another tough time will surely come soon. Some investors will be lucky enough to time a market drawdown well, but most will likely not. It is during difficult markets when alternative and hedged strategies can provide the most help.
As Warren Buffett coined, “the first rule of investing is to not lose money, and the second is to not forget the first rule.” It is essential because a 100% return is needed to recover from a 50% drawdown, while only a 33.3% return is needed to recover from a 25% drawdown. Stemming from the 2008 turmoil, the S&P 500 saw its max drawdown of -55.25% on March 9, 2009, whereas the HFRI Equity Hedge (Total) Index's max drawdown occurred on Feb. 28, 2009 in the amount of -30.59%, with far less volatility and a better path to recovery.
The true test of an investment approach or portfolio manager is to see how they operate over multiple market cycles. When that is done, the data may surprise many advisors (see Figure 2, above).
There's only one ETF designed to actively deliver the returns of the HFRI Equity Hedge (Total) Index, however, many other ETFs offer alternatives in both index and active approaches. Alternatives represent a broad category that can encompass a variety of strategies, so for an advisor, it is important to understand exactly what an ETF is doing. Similar to using the S&P 500 as a core and then building around it for equity exposure, a broad category strategy similar to the HFRI Equity Hedge can be a great place to start — and to build other, more focused alternative strategies around it. The good news for advisors is that these strategies are growing in the ETF structure so not only do they provide overall portfolio benefits, they also feature intraday trading ability, transparency and better tax efficiency than the mutual fund structure.
--- Read "Defending Alternatives in a Bull Market" on ThinkAdvisor.