Alternative Strategies: Preparing for the Unexpected

Mike Dieschbourg, managing director for the Alternatives/Managed Risk Group at Federated Investors, talks about why alternative investing strategies are gaining increasing traction with investors. The thing about volatility is it comes when few are expecting it. Consider the past 12 months. The fear gauge, aka the VIX, surged the first two months of the year on China and oil worries, settled down well below its historical median during the spring, spiked again on the Brexit vote and then settled back again to 2-year lows. This up-and-down movement can create havoc for the ill-prepared, generating losses and encouraging behaviors that work against a long-term investor’s interest. This is where alternative investing strategies can help. At its core, alternative investing strategies are dynamic. They tend to shy away from traditional diversification (60% stocks and 40% bonds) by including allocations to nontraditional, lowly correlated assets and/or by using supplemental strategies such as put or call options managed to limit losses or pursue opportunities during market declines. They recognize the traditional 60/40 model dates back more than 70 years, when the choices for investors essentially were just U.S. stocks and bonds. Now there are a near endless variety of alternative strategies and global securities that make traditional risk management and asset allocation difficult if not obsolete. Alternative investing strategies also are less obsessed with alpha generation than with loss reduction. It’s all about the math. To get back to breakeven on a 20% loss, an investor would have to earn 25%; recovering from a 50% loss would require a gain of 100%. And so on. The bigger the loss, the higher the recovery threshold. Therefore, if an investor can limit potential losses, he or she may be able to generate gains in line with if not higher than a portfolio that potentially earns more in up markets but is more exposed to losses in down markets. The goal is to get higher lows, though the converse—lower highs—can be and often are the case. Finally, alternative investing strategies are all about managing volatility. Investment options that seek to pursue alternative opportunities during market declines potentially can help ease the impact of wide swings in prices across asset classes—swings that can affect potential returns and take a long-term toll on portfolios. The chart above illustrates three different volatility ranges over a 10-year period, all producing a simple average return of 5%. But look at the difference between the no-volatility and high-volatility examples, with the high representing a volatility range of 50% (-20% to +30%). A $1,000,000 investment with no volatility would have been worth $412,000 more than the high volatility example and $7,250 more than the low-volatility examples (a volatility range of -5% to +15%). It’s all about compounding—bigger and/or more frequent losses disrupt the power of compounding, undermining potential returns. In sum, the core tenets of alternative investing recognize that markets are fluid and dynamic, not static and normal. By looking beyond traditional diversification in portfolio construction, focusing more on loss reduction than alpha generation, and using strategies aimed at managing volatility, alternative investing strategies can help equity investors stay on track, particularly during periods of high volatility. For more information contact: mdieschbourg@federatedinv.com

Past performance is no guarantee of future results. Alternative investing, including use of futures and short positions, may involve risks different from or possibly greater than the risks associated with investing directly in securities and other traditional investments. G46047-04 (10/16) Federated is a registered trademark of Federated Investors, Inc. Federated Equity Management Co. of Pennsylvania 2016 ©Federated Investors, Inc.