Is Now the Time to Introduce Alternative Strategies into Your Investment Portfolio?

Is the traditional 60/40 portfolio being challenged by a new paradigm? That archetype relates to the historically negative correlation between bonds and equities. This year the two major asset classes have experienced a positive correlation, move in the same direction, causing investors to wonder if this type of environment will last longer. If it does, this could be a great opportunity to introduce alternative strategies into a portfolio. We believe this strategy can help you meet your overall goals while maintaining the overall risk profile of a portfolio at its desired level.

One of the most important dynamics in building portfolios is the stock to bond correlation. Bonds are in portfolios predominantly for two reasons: capital protection during volatile stock market periods and yield. Currently, yields are at, or close to, historically low levels. More importantly, the traditional reliance of fixed income for capital protection in volatile markets is being tested; a potential inflationary environment would bring with it a heightened level of interest rate risk. Interest rate risk is based on the principal that interest rates and bond prices move opposite to each other. However, the moves in bond prices is not uniform across all maturities. In general, the longer the duration, the more the bond’s price will drop if there is a rise in interest rates. Currently, bond indices are trading at higher durations than their historical averages; combine that with the low level of yields and the result is an increased level of interest rate risk.

What causes the stock to bond relationship to turn positive?
According to a research paper written by Junying Shen at Prudential Investment Management titled “US Stock-Bond Correlation What Are the Macroeconomic Drivers ?”^[1], correlations between the asset classes change during different macroeconomic regimes. The article points to the level and volatility of risk-free rates, the correlation of economic growth and interest rates, and the correlation of bond and equity risk premiums as main drivers of the connection between stocks and bonds. Interestingly, most investors probably demonstrate bias by referring to the relationship as always being in a negative correlated state. According to this article, the correlation was positive at varying degrees from approximately 1965-2000.

Are we entering a new macroeconomic regime?
Now could be the time to introduce alternative strategies into a portfolio that can exhibit a return/risk profile commensurate with the Barclay’s Aggregate Bond Index^[2] due to the heightened level of interest rate risk mentioned earlier. Differentiated strategies with portfolio managers that have illustrated a history of producing a similar return/risk profile compared to the bond index over a long period of time could become a larger percentage of portfolios over the foreseeable future. Strategies that might fit this bill: Merger Arbitrage, Long/Short Equity, Long/Short Credit, Option-Based Strategies, and CTA (Commodity Trading Advisors). Examined by themselves, these strategies introduce other risk elements into the portfolio including capital lockup risk, which places supreme emphasis on investment committee due diligence teams to select the manager in each respective area that has produced a history of controlling those risks. However, by introducing uncorrelated returns to other major asset classes, it can benefit a portfolio’s diversification profile for certain investors. In conclusion, for select investors, if the stock to bond correlation has shifted to a positive one over the longer term, these strategies can become a useful tool within portfolios to help mitigate risk through diversification and allow portfolios to meet their long-term target returns.