In this, the second of our two-part series on strategies for advisors and their clients to replace their current fixed-income exposure (see part one here), we’ll focus on what to look for in an alternative mutual fund or ETF and the use of scenario testing.
So we’re mostly in agreement that interest rates will head higher. Whether they come a lot sooner or a little bit later, these rising rates have the potential to destabilize asset allocation models. We can also agree that advisors, unlike their counterparts of years past, have options beyond quality and duration to help manage their way through the coming fixed income challenge.
As discussed in part one, the good news is that investments in categories like High Yield, Floating Rate Loans, Emerging Market Debt, and Dividend Paying Equities can help fill the fixed income space in an asset allocation model. The better news is, we believe there’s more.
Enter the Alts
Indeed, beyond what would be considered more ‘traditional’ approaches, today’s investment professionals have access to the rapidly-expanding alternative (or non-traditional) fixed-income space. Broadly speaking, these are fixed income strategies designed to provide just what asset allocators are, or will be, looking for: Uncorrelated returns and lower volatility.
And just how do these strategies perform this kind of magic in a rising interest market? The easy answer is these not-so-easy approaches rely on high active management discretion that is not restricted to any investment style. This space consists of managers who have the ability to buy bonds, decrease duration, short bonds, buy derivatives or go to cash if need be to protect capital. Many utilize leverage. These are classic go-anywhere approaches, in other words, and they are the epitome of short-term, dynamic trading strategies.
Figure 1: Alternative Bond and Hedging Strategies Overview
Well-run funds and strategies, including certain merger-arbitrage and market neutral offerings, can limit interest rate risk by maintaining shorter durations and add alpha through diversification across a broader opportunity set, all with relatively low correlation to bonds and equities. Moreover, these low volatility, low duration strategies can act as a portfolio stabilizer—the same role core bond allocations have played for the last thirty years—in a rising-rate environment.
It’s also important to note that alternative strategies, with their flexibility around trade structure and investment horizon, can still provide an attractive yield in the form of short-term capital gains. That’s not the same as a bond coupon—there’s no guarantee and returns will vary over time—but alternative strategies can produce compelling yields with less sensitivity to interest-rate volatility.
What to Look For in an Alternative Offering