PANC 2015: Using Alternatives in Rising-Rate Environment

“We have done a lot of analysis, and we are very confident that a wide blend of alternatives will perform well in a rising interest rate environment,” said Ben Rotenberg, a portfolio manager specializing in alternative investments for Principal Funds. “In particular, a liquid basket of diversified hedge fund strategies should be a very compelling investment option in the years ahead, inside and outside defined contribution [DC] plans.”

Sirion Skulpone, head of liquid alternatives product strategy for Goldman Sachs Asset Management, agreed with the sentiment that now’s about as good a time as any for DC plans to consider adding liquid alternatives. Like Rotenberg, she advocated for a diversified basket of hedge fund strategies, “which tend to have low to negative correlations with the Barclays Capital Aggregate Bond Index.”

“In fact, six or eight weeks ago probably would have been the best time to move into these strategies, before this latest round of volatility really took off, but the timing is still right,” Skulpone said. “Beyond the very likely prospect of rising interest rates, equity valuations also make a good case for turning to liquid alternatives. Valuations have come down somewhat with the losses of recent weeks, but even given the volatility, equities are still relatively highly valued compared with historic averages.”

Rotenberg agreed, noting the “traditional 60/40 portfolio of stocks and bonds” has had a good run in the last three decades, as bonds have ridden interest rates down over the last 35 years. But will this continue? Unlikely, he said.

“It’s been a great time from an absolute and risk-adjusted perspective to own this portfolio,” Rotenberg. “Frankly, it’s been hard to beat, but we need to ask whether the last 35 years look like the next 35 years, and especially the next five years. The next five years will not look like the last five years.”

Both Rotenberg and Skulpone suggested the risk-adjusted return on a 60/40 portfolio is going to come down, so that makes today a sensible time to consider including some alternatives.

NEXT: Will the 60/40 portfolio hold its own? 

“Some ways of thinking about building an allocation—it’s going to have to be 10% of the portfolio at a minimum to have a real impact,” Rotenberg said. “Is 20% better than 10%? Yes. Is 30% better than 20%? Yes. Obviously you have to take liquidity into account, and the portfolio probably shouldn’t be all alternatives, but we’re strong advocates for including a substantial alternatives allocation in a DC plan portfolio.”

Skulpone agreed, noting the vast majority of institutional users of alternatives are allocating to a group of managers and a bucket of different strategies. “You need to know what you’re getting from a risk-return perspective,” she said. “There are single-strategy funds out there that are quite risky, for example, so you need to be sure you are pursuing the right alternative approaches. Again, it’s the bucket of diversified alternative strategies that are most appropriate for DC plans.”

In terms of what part of the portfolio should be reduced to add alternatives exposure, Skulpone generally recommends “funding this out of equities.”

“We think about alternatives as a tool to reduce risk and improve risk-adjusted returns, so it makes sense to fund from equities, from that perspective,” she said. “This could change, however, given what we have said about a new environment that is emerging. If you’re bearish on fixed-income going forward, you can consider funding from that portion of the portfolio. But alternatives are not less risky than bonds for the most part, so you’ll actually be increasing risk and potential volatility.”

Rotenberg agreed that alternatives allocations should probably come out of the equity portion of the existing portfolio.

“Hedge funds and alts have lower risk than equity, but they are more risky for the most part than fixed income, so keep that in mind,” he concluded. “Alternatives will boost the return profile over bonds, but [they] will also boost the risk profile.”