If Rising Rates Have You Rattled, Here Are 3 New Ways To DiversifySubmitted by Silverlight Asset Management, LLC on October 11th, 2018
Many investors have been learning an unpleasant lesson lately. That is: stocks and bonds can lose money simultaneously. For instance, last week both of the major asset classes declined about 1%.
1% doesn't qualify as a big move in the stock market. But for bond investors, it stings.
The Vanguard Total Bond Market ETF (BND) peaked on September 8, 2017. Here is the cumulative performance since then across a range of maturities.
|Bond ETF||Total Return|
|Vanguard Total Bond (BND)||-2.9%|
|1-3 Year Treasury (SHY)||-0.5%|
|3-7 Year Treasury (IEI)||-3.3%|
|7-10 Year Treasury (IEF)||-5.9%|
|20+ Year Treasury (TLT)||-9.3%|
If rising rates have you rattled, now is a good time to consider diversifying your diversifiers.
A sea of investors are parked in traditional 60/40 (stock/bond) balanced portfolios. 60/40 was a great mix over the last 30 years. But interest rates now reside at entirely different levels. As conditions change, so should strategy.
I've been steering balanced investors I work with toward a 60/20/20 portfolio. Here are several ideas from my 20% sleeve of 'alternatives,' which I view as bond substitutes.
Before interest rates peaked in 1982, traditional balanced portfolios didn't work very well. In fact, from 1972 to 1982, 3-month Treasury bills actually outperformed both stocks and long duration bonds. Cash was king in that era.
I don't see real rates shooting up to the heights witnessed in the 1970s anytime soon. But I do think the secular outlook for bonds is poor, and I am content to hold some extra cash.
For starters, unlike five years ago, cash actually pays something today. 1-year CDs yield around 2.5%.
Unlike 2013, when the "taper tantrum" sparked a rally in yields, the yield curve is now flat. Hence, investors aren't being well compensated to take on extra duration risk. Unless it's a tactical trade, why take the duration risk of a 30-year bond, if the yield isn't much higher than what short-term CDs pay?
Another thing to consider with cash is that it becomes a progressively more reasonable option as a market cycle ages. Cash begins to have scarcity value.
If you're positioned to deploy cash into distressed assets when the next liquidity crunch arises, you not only limit your downside exposure—which helps compound higher returns in of itself—but you also achieve attractive entry prices on new purchases. However, you can only get to that enviable position if you do the hard thing first. That is: raising cash when market conditions are still favorable.
2. Merger Arbitrage
Merger arbitrage strategies seek to capture the return opportunity associated with the natural deal spread that emerges after M&A announcements. The strategy exhibits a low correlation to traditional stock and bond benchmarks, since performance is mostly based on the ability of managers to evaluate the probability of individual deals closing.
Merger arb was once a sophisticated strategy only available to high-net worth investors in hedge funds. Nowadays, more people can access this type of strategy via mutual funds.
One fund you may want to consider as a bond substitute is the Vivaldi Merger Arbitrage Fund (VARBX). Reasons I like it:
Seasoned managers, whose track record stretches back to 2000
- 10.1% ann. return since inception
- Zero losing years (they even made money in 2008)
- 2018 is on track to be a record year for M&A, which means more deals to choose from
- The 'arbitrage spread' in M&A transactions tends to increase as rates rise, because the risk-free rate is the primary input into any M&A spread
Note: there are two tickers. The institutional class (VARBX) has a lower expense ratio, but requires a minimum investment of $500,000. The retail class (VARAX) has a higher expense ratio with a minimum commitment of $1,000.
3. Long/Short Equity
Another vehicle I like is the Gotham Absolute Return Fund (GARIX). It's run by one of my investing idols, Joel Greenblatt, and his team of analysts.
According to Gotham's website, GARIX is "a long/short U.S. equity fund with a net long exposure of 50%-60% (e.g., 120% long vs. 60% short = 60% net long). The Fund seeks long-term capital appreciation and to achieve positive returns during most annual periods in an efficient, risk-adjusted manner."
GARIX has returned 7.9% annually from its inception in 2012 through Q2 2018. That compares favorably to the HFRX Equity Hedge Index's 3.8% annualized return over the same period. And the fund's cumulative return of 60.3% has clobbered the Barclays Aggregate Bond Index (+8.2%).
Historically, Gotham's spreads typically perform best following periods where: (i) the broad market is expensive, and (ii) the most expensive stocks (i.e. growth stocks) handily beat the cheapest stocks (value stocks). Presently, both conditions apply.
Gotham recently communicated that in the year-to-date period through August 31st, money losing companies in the Russell 1000 Index returned 15.7%.
Imagine that: if you could go back to the beginning of the year, and restrict your portfolio to solely unprofitable firms, you'd be outperforming. Defies logic, right? The same trend appears in the Russell 2000, where the average return of negative cash flow firms was +18.4% over the same period.
Speculative conditions won't last forever. Eventually, losing money catches up with companies, particularly during broad market dislocations. When that happens, I expect Gotham's long/short spreads to widen considerably.
Between here and there, I like the fund's return prospects compared to bonds.
Remember investing is all about managing risk and return. With bonds yielding very little, investors are well-served to adopt a more creative mindset with their asset allocation.
Thankfully, investors have more alternatives to choose from today than ever before.
Originally published by Forbes. Reprinted with permission.
Disclosure: I own VARBX and GARIX in accounts which I professionally manage.
This material is not intended to be relied upon as a forecast, research or investment advice. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.