“You’re Going to Need a Bigger Boat”: Alpha and Interest Rates

Caution has been the dominant sentiment among investors in recent times even as equities have continued to march along. But as the prospect of rising US interest rates becomes ever more real, Brooks Ritchey, senior managing director at K2 Advisors, Franklin Templeton Solutions, takes a look at how some individuals and institutions are changing their guarded approach. He says alternative investments could find increased interest among savvy investors as interest rates start to tick higher.

Every year during the dog days of summer, coinciding with Discovery channel’s immensely popular “Shark Week” programming, it seems that references to Steven Spielberg’s classic blockbuster movie Jaws abound. And this year was no different.

To me, Roy Scheider’s infamous line about needing a bigger boat (a brilliant ad lib by the way) allegorically brings to mind the current state of the markets.

While the market appeared relatively tranquil on the surface during the second quarter, an over-arching theme has been an increasing sense of trepidation—or uncertainty—related to potential threats lurking below.

Macroeconomic concerns, including geopolitical hot spots, China’s status, and whether or not global GDP growth can be sustained, all pose legitimate problems for market stability. As market volatility has increased we have seen signs of tension surface in recent weeks.

In our view, perhaps the most significant and pressing concern today, and certainly one the majority of market observers are keenly focused on, is the threat of rising interest rates in the United States. Given the current market environment, particularly as it relates to fixed income securities, rising interest rates could represent a macroeconomic risk for portfolios not suitably positioned. Despite the fact that a rise in interest rates is seen as an eventual certainty by market watchers, there are solutions for investors looking to weather the possible storm. We think seeking to inject some alpha—or manager-added value—into portfolios constructed largely on the basis of equity and bond exposure to general market conditions, could provide a better “boat.”  

I want to highlight the relationship I see between alpha–which we define as a risk-adjusted measure of the value that an active portfolio manager adds to or subtracts from a portfolio’s return—and interest rates, and why in my view a portfolio constructed with alpha components can potentially prove beneficial when the inevitable rate rise surfaces. There are several other points with regard to alpha that I think are worth noting.

Alpha is a measurable and tangible market by-product. It is the noise inefficiency residual that shadows the market signal, and it creates a value ‘song’ that can be captured and appreciated by market participants with discerning ears…and the right equipment.

Another observation I would like to make relates to alpha and its cyclical nature. Alpha, like many other aspects of the market, is a cyclical phenomenon that waxes and wanes with macroeconomic environments, demographics and investor behaviors. Alpha can be stronger on average in some economic cycles or environments, such as periods with higher interest rates, and weaker in others.

The last point I would like to make relates to alpha and the strong relationship I have observed it has had with interest rates.

I should note that most financial market observers believe the US Federal Reserve will start to raise interest rates at some point in the not-too-distant future, perhaps as early as the second half of 2015. Fixed income has enjoyed a bull market rally spanning close to 30 years now, give or take a few outliers here and there such as 1994. US interest rates have steadily declined from the mid-teens in the late 1970s to single digits today.

 

This inexorable decline and associated increase in bond prices has helped protect many investors against rate and duration¹Â risk for an extended period. But it seems inevitable to us that this long-term trend of lower rates and higher bond prices will likely eventually reverse, and not preparing for this shift appropriately will leave some boats taking on substantial water.

With rising rates being the likely course ahead, we see many institutions seeking to reduce  these risks by looking to alternative investment funds that use alternative strategies, where portfolios can be structured that seek to soften interest rate and duration exposure.

We believe alternative strategies used within a retail mutual fund can be particularly attractive in a rising rate environment because they can be structured with the goal of providing both potential protection, and also potential gain, from rising rates.

Alternative investments cover a varied set of asset classes and strategies that go beyond traditional stocks and bonds. Alternative investment asset classes include real estate, real assets (e.g., commodities, infrastructure) and private equity, while alternative strategies primarily consist of hedge strategies. Hedge strategies typically have the ability to utilize short positions (i.e. seeking to profit on a decline in value of an individual security or index) in contrast to traditional mutual fund strategies which typically permit only long positions.

A hedge fund is a pooled investment fund, usually a private partnership, that seeks to maximize returns using a broad range of strategies, including unconventional and illiquid investments.

© Franklin Templeton Investments

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