Investing in Alternative Strategies:

A heightening degree of correlation between traditional asset classes such as Equities and Bonds, both domestic and international, have led many investment managers and advisers to seek alternative investment strategies that exhibit lower correlation to traditional assets in a bid to diversify their clients’ portfolios. Alternatives asset allocation in Australia has achieved significantly higher organic growth rate over 2021 (16.7%) and 2022 (18.9%)[1], suggesting that advisers have paid particular attention to these strategies and have increased allocations in recent years due to the correlation dilemma that they face in traditional asset classes.

Alternative strategies include market-neutral strategies that have a near zero correlation with equity markets, with correlation ranging somewhere between -0.3 or 0.3. This means that the movement of the returns for a market neutral strategy are not tied in any specific way to the returns of the broader market.

Market neutral strategies can be an important component of portfolio diversification as they offer the prospect of positive returns, irrespective of market conditions. As such we’ve decided to cover some of the major alternative investment strategies that are available to investors:

Long/Short

Market Neutral strategies aim to generate investment returns that are independent of changes in the broader market environment. In an equities-based fund this is typically achieved by a fund manager making both long and short investments on equities. A long position is typically achieved through the traditional sense of buying a company’s shares in the hope that the price of the shares appreciates. Taking a short position on a company pays off if the value of that companies shares drop. This can either be done through derivatives instruments or through borrowing stock and selling it into the market, with the idea of buying it back at a lower price and closing your obligation to the borrower, profiting off the difference between the buy price and the sell price.

Long/short equities strategies typically have low correlation/ market neutrality as short positions should benefit from drops in the broader market, whereas long positions should benefit if the market rallies. The outperformance comes from management skill in picking companies that are either overvalued (initiate a short position) or undervalued (initiate a long position) and are therefore going to be discovered overtime to be reflected in the share price. There is a bit of contention as to whether Long/Short equity funds are market neutral, as they tend to have a higher allocation to long equities and therefore exhibit higher correlation to the market.

Trend following strategies

Is a relatively self-explanatory strategy that looks at the directional change and strength in the movement in price of an asset and allocates to it accordingly. These strategies aim to take advantage of long, medium or short-term trends in various market settings and deploy a range of different methodologies to calculate these trends. Trend following is commonly used by Commodity Trading Advisers (CTAs) who use an array of quantitative models to determine the establishment of a trend and invest based on the trend following signals in the model. This typically involves the use of derivatives instruments such as futures to take positions in either the appreciation or deprecation of the commodity or asset price.

CTAs will typically employ two main trend following Strategies: discretionary or systematic trading. Systematic trading has distinguished rules that will determine the entry and exit points of a trade and are typically automated. Discretionary strategies are less rules dependent and are reliant on the manager expertise to spot trends in the market.

Arbitrage Funds

An Arbitrage Funds goal is to highlight mispricing in financial markets and take advantage of the differences in pricing between those markets. These funds will buy in the cash market (pay the current price) and sell in the futures market (contracts to be executed in the future) in an attempt to profit from the difference. Arbitrage funds will typically have low correlation to the market as the aim of the fund is mispricing of various securities and can also be employed across a number of different asset classes and instruments. For example, convertible arbitrage funds profit based on the pricing discrepancy between a company’s convertible bond and its underlying stock; the fund exploits changes in credit quality, interest rates and volatility to generate returns and manage risk. Merger Arbitrage funds attempt to play the outcome of a merger proceeding or not, and the likelihood of that happening that is not priced into the market.

Global Macro Strategies

Global Macro strategies generally create investment strategies based on economic and political views. A typical Global Macro fund trades a broad range of asset classes, geographic regions and financial instruments and tend to be systematic and dynamic. This diversification allows for fund managers to have low correlation to equities or bond markets as they tend to have the ability to invest across a wide range of asset classes and markets and can take both long and short positions on those assets over varying timeframes. Kenneth Heinz, President of Hedge Fund Research (HFR) has suggested that Macro strategies look promising given the current climate; “hedge funds have adjusted position to trends and drivers of performance which are not a continuation of the last two years, with primary focus on inflation and interest rate sensitivity, commodities, M&A and selective, hedged equities exposures”.[2]

Although these types of strategies are difficult to access directly for a retail investor, there are a couple of ways that clients can get a broader access to a basket of hedge fund strategies. If you wish to discuss this topic in further detail, please don’t hesitate to get in contact with the team at Sequoia Asset Management.

References:

  1. https://www.ardata.com.au/wp-content/uploads/2022/05/AFALandscape2022-AB_R2.pdf
  2. https://thefullfx.com/macro-strategies-show-worth-in-tough-2022-start-for-hedge-funds/

Disclaimer: The information in this document is of a general nature and should not be relied upon as it as been prepared without taking into consideration the objectives, financial situation or needs of any particular person. As a result, before acting on this information, a person should consider its appropriateness, having regard to their objectives, financial situation and needs. Information from third parties is believed to be reliable, however it has not been independently verified. While the information in the document is given by Sequoia Asset Management in good faith it does not warrant that it is accurate, reliable, and free from errors or omissions. Neither Sequoia Asset Management or its employees accept any responsibility for errors in or omissions from the information.