Alternatives For The Future

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Which liquid alt funds will fare best when rates go up?

Along with other Yuletide treats, some Yanks are now anticipating the gift of a Fed rate hike. Better-than-expected employment numbers, an uptick in the manufacturing sector and pickup in wages have given the U.S. central bank the backstory for normalizing the nation’s monetary policy.

The odds of a rate step-up, implied by Federal Funds futures, shot up from 7 percent to 70 percent in November. Simultaneously, expectations pushed the Treasury long bond yield up nearly a quarter of a point, effectively discounting the Fed’s anticipated action.

Now that the markets have priced in the first Fed rate hike, it’s debatable whether it will be “one-and-done,” or the first step along a steady path of snugging. Either way, the die is cast: Rates are bound to rise, and sooner rather than later. 

With the coming of the end of the zero-rate environment, investors and advisors must rethink their portfolio strategies, most especially their alternative investment allocations. The basic question facing them now is which exposures are most likely to continue providing risk diversification in a rising rate environment. 

To answer that question, let’s look back at the liquid alt universe over the past five years and gauge each category’s correlation to a fixed income market proxy, the iShares Core U.S. Aggregate Bond ETF (NYSE Arca: AGG). AGG tracks an index of investment grade notes and bonds including Treasuries, agencies and corporates as well as mortgage- and asset-backed paper, all with a weighted average maturity just under 13 years. Currently, AGG offers a 2.4 percent distribution yield.

Two Things

An ideal diversifier should be negatively correlated to AGG. Thus, when rates rise (and AGG’s price, as a consequence, falls), the alternative investment should appreciate. There are five categories that are negatively correlated to AGG: arbitrage, hedged equity, commodities, long/short equity and market-neutral.