It is common wisdom that domestic stock and bond markets are (depending on your view) either fully-valued or overvalued. While I have occasionally written blog posts aimed at debunking the ‘argument du jour’ for why these markets are set to move lower, I do not disagree with the general idea that stocks and bonds appear to be richly priced. Considering the reasons why this is so brings us to another bit of conventional thinking: the liquidity provided by the Federal Reserve Bank is the culprit. Fed policy is noted as the catalyst for asset inflation for several reasons, but one in particular - the ‘zero interest rate policy’ (or ZIRP) – is worth further consideration.
The reason that the ZIRP has had such an impact on stock and bond markets is that most asset pricing models use the risk-free rate as an integral part of the pricing calculation. Sometimes it is used as a base to which riskier returns are added, but most often the risk-free rate is used as a part of a discounting mechanism to value assets back to present value. So, when the risk-free rate is close to zero, these asset pricing models will tend to discount less, and therefore produce higher valuations. In this way, stock or bond prices may not be high relative to the risk-free rate, but that is because that rate itself is near zero. While the risk-free rate has gone up (slowly) over the last couple years, it continues to be low enough (and the market perceives that it will remain low enough) that asset prices continue to be elevated.
There is an acronym that is sometimes used to describe investing in this type of environment: TINA – ‘There Is No Alternative’. This attitude has some validity. After all, investors need to deploy capital somewhere. TINA, however, is quite literally wrong – there is an alternative, which is… alternatives.
More specifically, I am referring to hedged liquid alternatives that use strategies that are simultaneously long and short different securities. These include alternative asset categories like market neutral, managed futures, alternative risk premia, arbitrage, and global macro. The reason that these strategies are attractive relative to long-only investments is that the expensive asset valuation is washed out by the short side of the strategy. Consider a market neutral strategy that is both long and short stocks: the market valuation is no longer an issue because the strategy doesn’t have any net exposure to the stock market. The same holds true, in some fashion, for all the strategies listed above. In this way, hedged alternatives provide investors with options that don’t have traditional valuation concerns.
So, should investors pile into liquid alternatives? Piling in may be extreme for investors that are comfortable with traditional risk exposures like stocks and bonds, but reducing allocations to these markets in favor of hedged alternative strategies is worth considering. An investor that has a classic 60% stock and 40% bond portfolio might want to consider moving 10% from each traditional asset class into alternatives. A 50%/30%/20% portfolio would offer a more diverse blend of risk and return sources and would have less exposure to fully priced long-only investments.
Ultimately, some market observers think that as the Fed raises rates and unwinds its balance sheet, the same factors that caused markets to rally will reverse and the result will be that markets will plummet. There are many related questions that will affect the eventual outcome: Is the economic landscape strong enough to support monetary tightening? Will tax reform and fiscal policy help support the economy as the Fed removes stimulus? Is the Fed nimble enough to remove their accommodation without spooking the markets? We don’t need to pretend to have the answers to these questions. Instead, we can reach an easier conclusion: reallocating a portion of assets into alternative strategies that aren’t exposed to valuation concerns can help insulate investment portfolios from corrections.
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Important Disclosures: Liquid alternative investments entail different risks than traditional investments like stocks and bonds. Liquid alternatives often use derivatives, shorting, and sophisticated hedging techniques that may expose investors to additional risks including the risk of a loss of principal. An investor considering liquid alternative funds should be able to tolerate potentially wide price fluctuations. Liquid alternatives may be subject to high portfolio turnover risk as a result of frequent trading, and thus, will incur a higher level of brokerage fees and commissions, and cause a higher level of tax liability to shareholders in these investments. Additionally, liquid alternative funds generally have higher expense ratios than stock or bond investments. There is no certainty that any investment strategy will be profitable or successful in achieving your investment objectives.