Alternatives as bear market beaters

The U.S. stock market peaked in early 2000 and plummeted until late 2002. After reaching a new high in 2007, stocks fell sharply once more from late 2008 to early 2009. With the market once again at record levels, as of this writing, is another plunge likely?

If so, will any alternative investments help cushion the future shock? Some advisors look at the past and expect hedge-type funds and managed futures to be among attractive alternatives today.

“By our calculations, U.S. stocks are extremely overvalued now,” says David Strege, a senior planner with Sherpa Investment Management, a division of Syverson Strege and Co. in West Des Moines, Iowa. “However, we’ve been maintaining some exposure to the market, because we don’t want to miss a strong run.” Such participation helped last year, when domestic equities soared, but Strege’s firm has added some alternatives to provide downside protection.

LIQUID ALTS

“We’re not using illiquid hedge funds but we are using some liquid alts,” says Strege, referring to accessible funds that follow hedge fund strategies. In particular, the firm has been using liquid alts that have the capability of going short as well as long; Strege mentions long-short bond funds while Lance Gunkel, senior analyst at Sherpa Investment Management, notes that the firm uses a multi-strategy fund where an experienced manager can take short positions, if indicated.

MANAGED FUTURES

“We’ve also gone into managed futures,” says Gunkel. “According to our research, managed futures funds have been flat or positive in most of the historically worst days for the stock market.” Overall, managed futures funds have been down for nearly two years and capital is flowing out of them. They might represent a contrarian play as well as a possible buffer against a stock market skid, because of their low correlation to domestic stocks.

FUNDAMENTAL INDEX FUNDS

Beyond such alternative funds, Strege says that advisors may be missing some “low-hanging fruit” by not taking alternative approaches to their core equity portfolios. “We’ve been using fundamental index funds,” he says, “which aren’t weighted by market capitalization.” It’s widely-known that cap-weighted index funds became tech-heavy in the late 1990s and thus fell heavily in the 2000-2002 tech bust. Strege says that fundamental index funds—which are based on measures such as assets and revenues—also were relatively strong performers during the 2008-2009 financial crisis, taking losses that were much smaller than those of cap-weighted index funds.

LOW BETA BETS

Another tweak, according to Strege, is the adoption of a managed volatility approach. Generally, that strategy consists of choosing stocks and funds with relatively low beta: equities that have fluctuated less than the relevant benchmark. Some research indicates that low-volatility stocks might be excellent long-term performers. Gunkel says that his firm prefers active management in this area as he has concerns about low-volatility ETFs.

Both fundamental indexing and managed volatility vehicles are included as part of a client’s equity portfolio. Strege and Gunkel believe that such tilts may sacrifice some short-term upside but also provide downside protection to improve long-term results.