Alternative Investing in a Higher Rate Environment
By Kavan Choksi
The US economy has so far proved to be more resilient to higher interest rates than most economists predicted. Employment numbers look better than expected, and the likelihood of a recession has continued to fade. Inflation, while remaining stickier than most would hope, has dropped at a reasonable pace and sits just above the target of 2% that policymakers prefer.
While this is all good news from an economic perspective, it also means that there is no pressing need for the Fed to lower rates in the first half of 2024 and that rates may not need to be cut substantially in the second half of 2024, unless some unforeseen economic shock occurs. This puts investors in a bit of a dilemma. Yields will likely fall some from their current highs, but they may remain just attractive enough to put pressure on equity demand. Because of this, equity investors may need to take on riskier bets to achieve desirable returns over the next market cycle. Generally, taking on more risk in an equity portfolio correlates to a higher risk of a substantial drawdown. However, there are ways to moderate risk while seeking decent equity returns. It may be an opportune time to explore alternative investments as a way to manage overall portfolio risks.
Investors sometimes ignore or avoid alternative strategies because they are seen as sophisticated or risky. There is some truth to this – investors should understand any strategy they use in their portfolio. Investors should understand that, from a risk perspective, alternative investing strategies are usually employed to control some aspect of portfolio risk. As for alternative investing's complexity, gaining exposure to alternative strategies is often as simple as investing in an uncorrelated asset class through a professionally managed mutual fund.
More sophisticated strategies exist too, such as options investing described in more detail below. A knowledgeable broker can help guide investors through the complexity, and gaining experience in alternative investing can give investors new powerful investment tools.
Here are three potential alternative investments that can help investors seek higher returns while controlling portfolio risk.
1. Long/Short Funds:
Long/short funds offer simple exposure to a sophisticated strategy intended to mitigate market fluctuations, especially in a higher interest rate environment. These funds typically aim to generate returns regardless of market direction by simultaneously holding long positions in securities expected to appreciate and short positions in those anticipated to decline. In times of higher rates, traditional equity markets may experience increased volatility, making long/short funds an attractive option for investors seeking to mitigate downside risk while still maintaining exposure to higher-returning equities. By employing both long and short positions, these funds have the potential to provide a more balanced approach to returns, offering some protection for the possibility of a significant market drawdown while still capturing alpha.
When looking for a Long/Short Fund, seek an experienced portfolio management team with broad research capabilities. These funds can complement an equity-heavy portfolio but should not be a core portfolio holding due to the additional management and trading costs of the strategy, which increase the management fees beyond that of long-only mutual funds.
2. Precious Metals Mutual Funds
Precious metals, such as gold and silver, have long been regarded as safe-haven assets during periods of economic uncertainty and inflationary pressures. In a higher rate environment, where concerns about inflation may linger, precious metals mutual funds offer investors exposure to these commodities without the logistical challenges of owning physical bullion. These funds invest in a diversified portfolio of precious metal-related assets, including mining stocks and futures contracts, providing a hedge against inflationary risks and currency devaluation. Precious metals have historically exhibited low correlation with traditional asset classes like equities and bonds.
But the asset class can provide more than a hedge against potential market drawdowns. Perhaps surprisingly, precious metals mutual funds outperformed equities in terms of absolute wealth creation from 2000 to 2021[1].
3. Collar Strategies
Collar strategies offer investors a way to participate in the potential gains of riskier equities while simultaneously mitigating downside risk by using options. Options are financial instruments that give investors the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) within a specified period (until expiration). Options are often used to manage risk and enhance returns in investment portfolios. For instance, by buying a put option, investors can protect themselves against potential losses in the value of an asset, while buying a call option allows them to profit from potential upside moves.
A collar strategy involves combining the purchase of protective put options with the sale of covered call options on an existing equity position. Purchasing puts provide the right to sell the underlying equity at a predetermined price, regardless of how far its price may fall, establishing a floor for potential losses. Simultaneously, selling covered calls generates income that helps offset the cost of purchasing the protective puts. The result is a collar around the equity position, limiting both upside and downside potential. Collar strategies are particularly useful for investors seeking to invest in equities with higher return potential while mitigating the risk of taking those positions.
Several other popular options strategies exist to help tailor the risk of an equity portfolio to an investor's preferences, and once familiar with how options work, investors can employ them creatively. Options, however, are not for everyone. Using a trusted broker and understanding the costs and financial obligations of an options contract is imperative for investors wanting to utilize these alternative tools.
Balancing Risk and Reward
Alternative investing can help investors optimize their potential return for their preferred level of risk in a variety of market conditions. As indicated by the “alternative” label, these strategies should not generally be used as a core investment strategy. Instead, add alternative investments tactically to protect longer-term financial goals from various market conditions and threats. It's crucial to approach alternative investments with diligence and understanding, recognizing that each strategy comes with its own set of risks and considerations. However, investors should not hesitate to explore these investments because the potential to mitigate risk means that alternative investing can allow more possibilities for seeking return.
[1] Malhotra, D. K. (2023). Are Precious Metals Mutual Funds A Good Investment? The Journal of Beta Investment Strategies, 14(4), 65-80. https://doi.org/10.3905/jbis.2023.1.047
