This is the fourth in a series of blogs exploring the use of liquid alternatives by advisors, based on reporting conducted among advisors for the August 2014 Investment Advisor cover story, Alts Are the Answer.
As we wrote in our last blog on liquid alternatives, Aging Clients Mean Booming Market for Liquid Alts, more than 10,000 baby boomers turn 65 every day, and will continue to do so for the next two decades. For these folks, the mindset has shifted from portfolio gains to investment income. And a more stable net asset value is preferred to ensure that the income stream is not affected by dramatic market events.
These portfolios are dominated by credit, and in many cases high-yield bonds are a significant portion of the asset allocation. These securities offer investors a less volatile way to incorporate some equity-like upside, but the real draw for such bonds is income. The iBoxx High Yield Corporate Bond ETF (HYG), for example, has an SEC yield of 4.85%, which compares favorably to just about any liquid income alternative.
But there are risks to consider. Widening credit spreads and rising rates can create significant volatility in the market value of income-oriented portfolios, causing account values to drop and clients to question the worthiness of the strategy. What’s the best way to hedge against such an occurrence?
I’ve often pondered this question, and at the suggestion of a client found a surprising answer: managed futures.
To review, “managed futures” is a strategy of investing in a portfolio of exchange-traded futures contracts. These markets includes financial futures (Treasury bonds, currencies and equity index contracts), as well as agricultural and precious metals positions. Since most trading is momentum-based, managed futures investments tend to do well when volatility is rising and equity markets are in retreat.
Readers familiar with our previous research on managed futures as a diversifier have heard this story before. But even I was surprised to see how uncorrelated the strategy is with high-yield bonds (see Table I below).
Managed futures returns (as measured by the Newedge CTA index) during the ten largest losing streaks for high yield bonds (as measured by the Barclays U.S. Corporate High Yield Index). Source: Bloomberg LP.
At least anecdotally, it makes sense why managed futures makes such a good portfolio addition in an income-oriented portfolio. Credit instruments don’t change hands as frequently as stocks, and as a result the price of high yield bonds and other fixed income investments tend to trend. During downtrends, futures strategists can hold defensive positions, and the longer high yield prices drop, the longer a managed futures manager has to generate profits.
We plan on writing a research note on our findings. If you are interested in seeing the results, please email me at email@example.com.