There have been few places to hide for investors this year. Both stocks and bonds have tumbled – since the start of 2022, the Vanguard Balanced fund, a portfolio of 60% stocks and 40% bonds, has lost 13%. Moreover, interest rates are still rising, inflation is on the march, and the stock market continues to gyrate.
Investors have no control over rising rates or slumping markets, but they can even out the movements in their portfolios and potentially boost returns by investing some of their portfolio in alternative strategies that move out of sync with both stocks and bonds.
We’ll introduce three alternative strategies here: long-short funds, market-neutral funds and managed-futures funds. All are capable of generating positive returns during bleak periods for stocks and bonds; so far this year, many have.
Alternative strategies were previously available only to high-net-worth individuals, institutions or financial advisers. Today, a growing number of alternative strategies are available via mutual funds for mom-and-pop investors. Some money managers are making the case for putting 20% or more of your investments in alternative-strategy funds, depending on your age, circumstances and risk tolerance, given today’s volatile markets.
All nine of the funds we profile here are run by managers who have solid records and – critically for these types of strategies – strong histories of risk management. The funds are all widely available at most brokerage firms, though some may require a transaction fee. Fund expenses tend to be high due to some unusual operating expenses for the strategies and the high skill level of the managers, many of whom come out of the rarefied hedge fund world. Returns are through May 6.
1. Long-Short FundsMost investors hold stocks that they believe will rise in value and avoid securities they think will decline in price. But it’s possible to profit from both by buying and holding the companies you admire (going long) and by betting that prices of the stocks you dislike will fall (short selling). That’s the principle behind long-short investing.
“The ability to take long positions in stocks with superior return characteristics while shorting stocks with a poor outlook provides portfolio managers with more flexibility to utilize all the information they uncover during market research,” says Harindra de Silva, a manager at Allspring Global Investors.
These funds typically build their long and short bets with an overall target in mind for net long exposure, or the difference between the fund’s long and short positions. A fund that holds 80% of assets in long positions and 20% in short positions has a net long exposure of 60%. Depending on the manager’s view of the market, the fund’s net long exposure can shift up (a bullish outlook) or down (bearish). The lower the net long exposure of a fund, ostensibly, the less vulnerable it is to stock market swings.
These funds also invest with a target volatility – or beta – in mind. Beta is a measure of the volatility of a stock or portfolio in comparison to the market as a whole, which by definition has a beta of 1.0. A long-short fund manager might target a 0.5 beta as she builds her portfolio, which implies that it’s half as volatile as the overall market.
Short selling stocks can dramatically reduce the volatility of a stock fund, which helps to make it a valuable portfolio diversifier, and in the hands of skilled managers it can generate handsome returns over time. For instance, the AB Select US Long/Short Portfolio (ASLAX) returned 8.5% annualized during the past five years. That lagged the return of the S&P 500 Index, but the fund was 44% less volatile than the index during that stretch.
“Investors want to stay invested all the time, but they can’t take 50% drawdowns,” says Dane Czaplicki, director of research for Long Short Advisors, who suggests that investors move a portion of both fixed income and equity money to a long-short strategy.
The AB Select Long/Short, managed by Kurt Feuerman and Anthony Nappo, is in some ways relatively conservative as far as long-short funds go. The fund can short market indexes and single stocks, and it will build up its cash position as a hedge during volatile periods. The fund’s net long exposure has ranged between 30% and 70% historically, and at the end of March 2022 it stood at 49% – down 15 percentage points from the end of 2021. “Our goal is to capture a nice portion of market gains over time and protect capital in difficult times,” says Feuerman.
Feuerman is at heart an optimist. “We’re believers in the excellence of American business, the upward bias of markets over time and the benefits of compounding,” he says. Backed by a team of analysts at AllianceBernstein, the fund has added to energy and financial positions this year because Feuerman reckons that elevated levels of inflation are here to stay.
Boston Partners, a pioneer in long-short mutual funds, manages four portfolios, including the Boston Partners Global Long/Short Fund (BGRSX). The fund selects investments among 10,000 stocks listed around the globe, which are first filtered by a quantitative process that helps to identify statistically cheap stocks with good businesses for the long side of the portfolio and, conversely, low-ranked securities with declining earnings trends for the short side. The fund has gained 9.7% since the start of the year, compared with a 14% decline in its benchmark, the MSCI World index, thanks mostly to successful short positions in stocks including Netflix (NFLX) and Carvana (CVNA).
London-based comanager Josh Jones says today’s investing environment is analogous to the early 1970s, when a bull market memorialized by the “Nifty Fifty” growth stocks turned bearish after colliding with accelerating inflation. He says the fund’s net long position was recently below 45%, compared with 70% in 2020, and short positions made up more than 50% of assets at last report. “Volatility is great for us because it creates opportunities on the long side when stocks sell off, and positions on the short side work really well,” he says.
As with many dyed-in-the-wool value investors, the managers of the LS Opportunity Fund (LSOFX) scrutinize companies’ balance sheets and cash-flow statements before glancing at the income statements. It’s an important ingredient of risk management.
“We don’t care about the next quarter, and we don’t like to lose money – our money,” says comanager Kevin O’Brien, who, like his two comanagers, has invested a lot of his own money in the fund. And the approach is particularly useful for analyzing financial businesses such as banks and insurance companies, a sector specialty of LS. Financial stocks make up just over half of the fund’s current net long exposure of 60%.
O’Brien thinks we’re “in the early innings” of a cycle that favors value-priced shares because of higher interest rates and inflation. Unlike a number of long-short funds that are presently long on value stocks and short on growth shares, LS Opportunity holds value securities on both the long and short sides of its portfolio, which helps to tamp down volatility. The fund consistently maintains 50% to 70% net long exposure over full market cycles.
Harindra de Silva, armed with a doctorate in finance, has authored several seminal academic papers on long-short and quantitative investing. He has put theory into practice as comanager of the 361 Domestic Long/Short Equity Fund (ADMZX) and has earned solid long-term results. Central to his approach is the idea that low-volatility stocks deliver surprisingly high returns. Thus, he invariably buys long low-beta (or low-volatility) stocks and short sells high-beta (high-volatility) stocks, a strategy that should pay off well this year. “High-beta stocks in down markets tend to do really poorly, which gives us this down-market protection,” he says.
De Silva’s process is highly systematized. He examines 50 factors for each stock, such as quality, valuation and profitability, and then assigns weights for each factor in order to score and rank the securities. He says the fund essentially always holds a 70% net long exposure and sports a beta that’s about one-half of the stock market’s.
2. Market-Neutral FundsMarket-neutral funds are a long-short strategy with a twist: The funds balance long and short stock exposures in order to achieve a 0% net long exposure to the stock market. The result is a low-volatility portfolio that delivers modest returns. These types of funds generally don’t move in sync with stocks or bonds, so they make nice portfolio diversifiers.
Technically, Otter Creek Long/Short Opportunity (OTCRX) is a long-short fund. But Morningstar and other fund analysts place Otter Creek in the market-neutral camp because it shares similar characteristics with funds in that category: a low net long exposure (currently less than 10%), very low volatility and a history of incurring small losses in periods when markets are unfriendly. Comanager Tyler Walling, based in Palm Beach Gardens, Florida, likes to say that you “win by not losing.”
Walling’s “opportunistic” strategy is quite unusual. He studies the entire capital structure of companies and often chooses to invest in their bonds (including convertibles) rather than in their stocks if he believes the debt offers a better risk-adjusted return.
He short sells stocks he believes will decline, but also frequently expresses a negative view on securities by buying put options (a contract that gives you the right to sell a stock at a set price by a certain date) because he says it is a lower-risk way to profit from declining stock prices. Walling, who has two comanagers, says the fund can be used as an “equity-lite” alternative or to replace a portion of a fixed-income portfolio. Otter Creek returned a very respectable 8.0% annualized over the past three years, with less than half the volatility of the U.S. stock market.
The Vanguard Market Neutral Fund (VMNFX) is on a roll. Over the past 12 months, thanks to targeting a 0% net exposure to the stock market, the fund returned 24%, beating the S&P 500 by 24 percentage points – with less than half the volatility of the benchmark.
Matt Jiannino, Vanguard’s head of quantitative equity product management, attributes the outsize gains to nailing some dramatic shifts in the market, such as the flight out of “high-flying growth stocks,” he says, which the fund shorted. The fund also invested in stocks selling at reasonable prices with sound fundamentals (which were then “out of fashion,” Jiannino says) and consistent earnings growth.
Of course, it’s not as easy as it sounds. The fund’s computer models crunch the numbers on innumerable company characteristics and issue a report every morning. The fund’s long and short portfolios mirror each other, with 250 to 275 stocks on each side. And, unlike its peer funds, Market Neutral balances the short and long exposure for each market sector, too.
Although you shouldn’t expect Market Neutral to keep posting huge gains, its low-volatility profile makes it an appealing addition to a portfolio. “The key to investing is staying long term and riding out the ups and downs,” says Jiannino.
As with long-short strategies, market-neutral funds come in many shapes and forms. The Victory Market Neutral Income Fund (CBHAX) operates an unusual low-risk, modest-return strategy. It generates most of its return by harvesting dividends from four proprietary indexes of high-yielding stocks around the globe. To offset the long positions, the managers hold short positions in stock futures – contracts that allow the holder to buy or sell an asset at a set price on a future date – on major indexes, such as the S&P 500.
The fund currently yields nearly 3%, and it has returned 3.6% annualized over the past five years, with low volatility that’s akin to an index of investment-grade bonds during “normal” times.
Scott Kefer, a comanager, says that a typical investor should consider carving out some of his fixed-income allocation to invest in the strategy because it isn’t subject to interest rate risk and doesn’t track movements of either bonds or stocks. “There is always a place in a portfolio for a diversified yield stream,” he says.
3. Managed-Futures FundsAlso called systematic trend funds, managed-futures strategies use powerful computer models to profit from market moves, both up and down. The funds invest in futures contracts for a variety of assets, including commodities, fixed income (interest rates and bonds), currencies and stocks. Because the contracts allow holders to bet on prices to rise or fall, managed-futures funds can make money in good and bad markets. But they tend to perform best when investors need them the most – during severe stock market downturns.
Over extended periods, these kinds of funds can generate decent long-term returns, too. The typical systematic trend fund returned 9.3% annualized over the past three years. Add in the lower volatility that’s typical of these alternative-strategy funds, and it’s clear that managed futures can serve as an excellent diversifier in a multi-asset portfolio.
This year, the AlphaSimplex Managed Futures Strategy Fund (AMFAX) has provided a textbook example of how managed-futures funds perform in rocky markets: It has returned 34.3% amid bearish stock and bond markets so far in 2022 (and 17.4% annualized over the past three years).
Comanager Katy Kaminski says the environment of stress, dislocation and volatility in numerous markets around the globe is close to ideal for the strategy. She is one of several PhD holders involved in managing the fund. Their multiple computer models picked up several clear trends. Lately, the fund has been long on commodities and short on nearly everything else, from two-year Treasuries to stocks to the Japanese yen against the dollar. Given the one-way move (up) of interest rates this year, shorting bonds has been particularly lucrative for the fund.
“Most people are uncomfortable shorting bonds, and most regular investors are long-only in bonds,” she says.
Drawing on vast company resources, the PIMCO TRENDS Managed Futures Strategy Fund (PQTAX) invests in 150 different asset classes around the globe. “We want to have as many different things going on in the portfolio as possible for diversification,” says comanager Matt Dorsten.
This year, based on strong signals from their models stemming from factors such as high inflation and the war in Ukraine, PQTAX has been long on commodities and short on interest rates and sovereign debt.
“Trend following does well in crisis events because assets become correlated, creating strong, concentrated trends,” he says. The models also take advantage of investor behavioral anomalies, such as selling winners too early and, conversely, holding losers too long.
To manage risk, the managers scale positions according to asset volatility. For example, if wheat futures are particularly jumpy, they will hold a relatively small position. Over the past three years, the PIMCO TRENDS Managed Futures Strategy Fund has been half as volatile as the S&P 500, but the fund beat the bogey, with a 14.6% annualized return.