One Way To Survive Higher Interest Rates

July 17, 2014

With higher bond yields looming, using more ‘liquid alternatives’ may be one effective way to cope.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by K. Sean Clark, CFA, chief investment officer of Philadelphia-based Clark Capital Management.

Alternative investing has just about become a household name as more investors have gained access to alternatives.

Most alternative investment assets are still held by institutional investors or by accredited, high net worth individuals and, according to Preqin, now total $6 trillion.

However, in the last several years, alternative strategies have exploded into the retail marketplace. This growth has resulted in a wide variety of hedge-fund-type strategies being available through mutual funds and ETFs that are dubbed “liquid alternatives.”

Retail investors and asset managers now have access to managed futures, market-neutral, long/short equity, fixed income and many other strategies in a mutual fund wrapper—the same strategies institutional investors and endowments have been using for years.

In our view, access to these strategies via liquid vehicles provides advisors and investors with the tools needed to build better portfolios.

However, a liquid structure creates some trade-offs. Since underlying investments need to be liquid, liquid alternatives cannot invest in some of the less liquid instruments that have historically generated high returns in hedge funds. They also cannot use the same amount of leverage to goose returns.

On the other hand, liquid alternatives typically offer a number of appealing features, such as daily liquidity, lower minimum investments, transparency, lower fees and 1099 tax reporting instead of K-1s associated with futures-based investments. The trend of investing in alternative asset classes via liquid strategies has caught on.

According to Morningstar, $38.7 billion flowed into alternative investment mutual funds and ETFs over the year ended April 30, 2014. That’s about a 36 percent increase over the prior year and more than twice as much as two years ago.

When evaluating alternative investments, it’s important to understand their correlation to other traditional asset classes, stocks and bonds, as well as their correlation to other alternatives. And we believe one of the primary reasons for adding alternatives to a portfolio is to achieve noncorrelation to traditional asset classes.

The goal of modern portfolio theory is to blend different asset classes into a portfolio that seeks to reduce overall risk and volatility, and maximize return.

Historically, the addition of noncorrelating assets in a portfolio has seemed to lower overall portfolio volatility and improved the risk/return profile. The table below shows the correlation matrix between several alternative indexes from Hedge Fund Research and general market indexes over the past five years.

The matrix highlights that correlations vary greatly among alternative strategies when measured against traditional market indexes and against each other. Alternative asset classes have generally been negatively correlated to bonds and not highly correlated to equities, thus providing diversification benefit when allocated to a portfolio.

Alternative Correlations: 5 Years Ending 12/31/2013


Source: Morningstar Direct

For a larger view, click on the image above.

We often get the question, How much of a diversified portfolio should be invested in alternatives?

There is no single answer, as it depends on each client’s return objectives and risk tolerance, but we generally advocate that between 5 to 20 percent of a client’s allocation be to alternatives.

Allocation Specifics

For many investors who have enjoyed the run higher in global stocks over the past five years, it makes sense in our view to reduce risk and lower overall portfolio volatility by adding alternatives, especially given the current equity valuations and concerns over rising interest rates.

The weight given to alternative investments can come from either stocks or bonds, or a combination of both, with more coming out of traditional fixed income, which is what we generally advocate.

Investors have a dilemma. We believe they recognize that traditional fixed income may not provide the same diversification benefits it has in the last 30 years due to historically low interest rates combined with the threat of future inflation and rising interest rates. At the same time, they need to find ways to lower portfolio volatility and risk without adding fixed income.

The growth of the liquid alternatives asset class appears to indicate that advisors and investors are addressing this dilemma by using alternatives.

The proliferation of ETFs investing in nontraditional asset classes has democratized investing in alternative asset classes. The days of buying gold and real estate and calling it a day are long gone.

We advocate allocating to a broad set of alternative investments in an effort to gain robust exposure to the category and realize the diversification benefits of alternatives that were not possible for most investors before the introduction of liquid alternatives.

We think it makes sense to take a core-and-explore approach to the category by allocating to a handful of core alternatives to gain beta and then tactically managing long/short exposure in currency, commodity, equity and fixed-income allocations.

In our view, ETFs make tactically allocating attractive and cheap. No longer does an investor need to allocate to a managed-futures manager and pay high fees to gain access to the space.

Tactical choices that we currently favor in commodities are the iPath S&P GSCI Crude Oil ETN (OIL | A-92), the ETFS Physical Palladium (PALL | A-100) and the iPath Cocoa ETN (NIB | B-96). In addition, gold’s trend appears to be improving given the geopolitical tensions around the globe, and a close above $134 in the SPDR Gold Shares (GLD | A-100) would be a breakout.

In our opinion, a practical way to allocate to liquid alternatives is through a manager with a seasoned track record in the space.

Clark Capital Management Group is an independent investment advisory firm providing institutional-quality investment solutions to individual investors, corporations, foundations and retirement plans. Clark Capital was founded in 1986 and has been entrusted with approximately $3 billion in assets. For more information about Clark, contact Advisor Support at 800-766-2264 or [email protected]. Please click here for a complete list of relevant disclosures and definitions.

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