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How To Look at Alternatives in the Middle of Market Volatility?

Government lockdowns resulting from the COVID-19 pandemic threw the global financial markets off stride in March. As it turned out, alternative investments lived up to their promise of risk mitigation relative to traditional portfolios composed mainly of stocks and bonds.

You’ve no doubt read all the headlines by now, including:

“Fastest bear market in history.”

“Worst global recession since the Great Depression.”

“Unprecedented monetary policy in response to severe economic downturn.”

The COVID-19 pandemic was one of the most volatile investment periods in history. The CBOE Volatility Index, commonly known as the VIX, peaked in the mid-80s in March exceeding the peaks of the 2008-09 financial meltdown.

Alternative investments – an umbrella term describing assets that fall outside of conventional investment categories like stocks, bonds and cash – have been growing in popularity since the global financial crisis. Appetite for alternatives, which includes hedge funds, venture capital, real estate, precious metals, private mortgages and tangible assets, has continued to grow amid the pandemic.

Alternatives are now a $10 trillion market, and are expected to reach $14 trillion in 2023, according to Preqin research.

Find out more about portfolio management concepts under our Portfolio Management Channel

Alternatives Outperform Broader Market

In terms of overall market performance, alternatives outperformed traditional portfolios composed of stocks and bonds during the height of the COVID-19 crisis. Nowhere was this more apparent than gold, which gained 4% in the first quarter and fell just 3.6% in a month that saw the S&P 500 and TSX Composite crash by 35%.

Liquid alternative funds in the U.S. and other markets also outperformed the broader equity markets. Even hedge funds outperformed. According to The Wall Street Journal, the $3 trillion hedge fund industry lost just 3.04% in the first two months of 2020 compared with an 8.27% loss for the S&P 500. Preliminary first-quarter data showed a loss of 7% for hedge funds in the first quarter compared with the approximately 20% plunge for the S&P 500.

It’s important to point out that not all alternative assets performed equally well during the crisis. Real assets, such as infrastructure and real estate, showed mixed performance due to a variety of factors. Being publicly or privately listed and tied to the energy sector had a direct impact on their results.

Ultimately, the performance of alternatives during volatile market cycles depends largely on their correlation profiles, investment objectives and their management teams’ expertise. Research from Preqin shows that investors are increasingly turning to alternative investments for their diversification benefits, potential for high risk-adjusted returns, low correlation to other assets and reduced portfolio volatility. Investors are also turning to alternative assets to generate reliable income streams, hedge against inflation and generate high absolute returns.

Reliable sources of income are becoming more important in the age of ultra-low bond yields. With central banks committed to keeping interest rates at record lows, alternatives such as real assets, private mortgages and real estate are growing in popularity.

If you are considering investing in gold, check out this article.

Optimistic Outlook on Alternatives

While demand for alternative assets has been growing for decades, the period following the 2008 financial crisis witnessed a dramatic surge in investing activity. Alternative investments under management more than doubled between 2008 and 2017, with private equity and hedge funds leading.

The fallout from the COVID-19 pandemic is likely to keep alternative assets growing at a significant rate in the coming years. Major investment themes tied to the global economic rebound, inflation and monetary policy highlight the need for portfolio diversification, inflation hedges and reduced portfolio volatility.

Although the global economy is healing, the economic rebound is expected to play out over many years. It remains to be seen whether sectors tied to discretionary consumer spending, travel and hospitality will ever rebound.

And while the U.S. stock market experienced a ‘V-shaped’ recovery, it took extraordinary fiscal and monetary stimulus to do so. The Federal Reserve’s balance sheet has swelled to $7 trillion and the commitment to zero-bound interest rates is likely to continue at least for the next couple of years. Fed Chair Jerome Powell says the central bank will let inflation run hotter than its 2% target to achieve its macroeconomic objectives.

Wondering what liquid alternatives really are? Check out our previous articles on the topic here and here.

The Bottom Line

Alternatives stood up to the COVID-19 crisis test, but their performance varied greatly across assets.

Investors looking to diversify away from the traditional portfolio of stocks and bonds should do their research and talk to a financial adviser before making a complicated investment decision.

Be sure to check our News section to keep track of the latest updates from the mutual fund industry.

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Sep 23, 2020