Allocating to Liquid Alternatives: Enhancing Portfolio Diversification with Equity Market Neutral

Insights

Allocating to Liquid Alternatives

JOSEPH S. GIROUX
PORTFOLIO MANAGER

MICHAEL LABELLA, CFA
HEAD OF GLOBAL EQUITY STRATEGY

OCTOBER 26, 2018

Enhancing Portfolio Diversification with Equity Market Neutral


With the growth of liquid alternative offerings, equity market neutral is now broadly available across a number of vehicles, including mutual funds and separately managed accounts, making it a compelling alternative for all investors seeking to capitalize on diversification, commonly referred to as the only free lunch in investing.

As we reach the later stages of an almost decade-long bull market, against the backdrop of rich equity valuations in the US and expectations of rising interest rates, prudent investors have started to consider reigning in portfolio risk. Poised to benefit from higher interest rates, with low correlations to equities, fixed income, and most financial assets, equity market neutral strategies offer a compelling case for investors.

The renewed appeal of this strategy comes as we approach the end of the current cycle and a potential breakdown in the negative correlation between stocks and bonds; a benefit which investors have enjoyed over the last 20 years. Market environments in which stocks and bonds are positively correlated, such as the 1970-90 period, require investors to resort to alternative sources of portfolio diversification. Equity market neutral offers this diversification benefit and the opportunity for gains regardless of market direction, making it a compelling alternative for investors seeking to capitalize on diversification, commonly referred to as the only free lunch in investing.

What is an Equity Market Neutral Strategy?

Equity market neutral strategies are designed to profit from both rising and declining stock prices while virtually eliminating exposure to broad equity market risk. By taking long positions in securities expected to outperform and offsetting these with short positions expected to underperform, this strategy is positioned to profit without relying on the direction of the broader equity market. Additionally, equity market neutral has two potential sources of returns (Exhibit 1):

1. The spread in returns between the long and short positions (the strategy generates positive returns when the long portfolio outperforms the short portfolio)

2. Interest payments on cash, which includes the short sale proceeds held by the broker until the short sale is covered. The interest rate paid is a blend of Global Central Bank rates (net of broker fees and borrowing costs).

Exhibit 1: COMPOSITION OF EQUITY MARKET NEUTRAL TOTAL RETURNS


Source: QS Investors.

Focused on generating alpha, the risk and return profile of equity market neutral strategies differs significantly from long-only and other long-short equity strategies. Equity market neutral offers equity exposure with a risk profile more closely aligned with bonds, and a higher Sharpe Ratio (Exhibit 2).

Exhibit 2: US EQUITY, US FIXED INCOME, EQUITY MARKET NEUTRAL RETURNS, RISK AND SHARPE RATIO

January 1990 to June 2018


Source: StyleAdvisor.
Returns and volatility are annualized. The proxy for US Equity is the S&P 500. The proxy for US Fixed Income is the Bloomberg Barclays US Aggregate Index. The proxy for Market Neutral is the HFRI Equity Market Neutral Index. Please refer to Important Information at the end of this document.

Untethered to Equity and Fixed Income Markets

Despite being implemented with equities and equity-like instruments, most equity market neutral strategies target a zero beta to equity markets. In fact, the US equity market neutral strategies index had 0.06 beta to US Equity for the January 1990 to June 2018 period. More importantly, equity market neutral has held-up especially well during falling equity markets (Exhibit 3).

Exhibit 3: EQUITY MARKET NEUTRAL RETURNS DURING WORST 100 MONTHS FOR US EQUITY

January 1990 to June 2018


Source: StyleAdvisor and QS Investors.

In addition, equity market neutral has a very small beta to fixed income markets. The index of US equity market neutral strategies had 0.09 beta to US Fixed Income for the January 1990 to June 2018 period. Equity market neutral strategies have generated positive performance during rising, falling and stable rate environments (Exhibit 4).

Exhibit 4: EQUITY MARKET NEUTRAL RETURNS IN PERIODS OF RISING, FALLING AND STABLE INTEREST RATES1

January 1990 to June 2018


Source: QS Investors, HFRI and MSCI.
Average monthly returns, annualized.

Benefits from Higher Interest Rates

With interest payments being a component of total return, equity market neutral actually benefits from higher interest rates. When short-term interest rates are low, the interest accrued is generally immaterial and may not offset the costs of borrowing. However, when short-term rates are higher, the interest component of the returns can be meaningful. Proceeds from short sales during the last nine years of low rate environment were minimal, but hovered around 4-5% during periods with higher interest rates, like the 1990s (Exhibit 5).

Exhibit 5: EQUITY MARKET NEUTRAL RETURNS AND US FED FUNDS RATE

January 1991 to December 2017

 
Source: QS Investors, HFRI and Federal Reserve Bank of St. Louis.

Low Correlation to Other Traditional and Alternative Assets

An allocation to equity market neutral may be an effective portfolio diversifier as it introduces a new source of returns with low correlation to most financial assets (Exhibit 6).2 For this reason, equity market neutral appears to be an effective addition to a portfolio in the current market environment, but more generally, in any market environment as it enhances portfolio diversification.

Exhibit 6: CORRELATIONS EQUITY MARKET NEUTRAL TO A SELECTION OF FINANCIAL ASSETS

January 1990 to June 2018


Source: StyleAdvisor and QS Investors.

Enhancing Diversification in Traditional Portfolios

An allocation to equity market neutral can be funded by either equities and/or fixed income. Over a period close to 30 years, adding an allocation to equity market neutral to a portfolio improved its returns and/or risk profile (Exhibit 7). Allocations funded from equities generate a significant increase in the portfolio’s Sharpe ratio, driven by a reduction in risk. Allocations funded from fixed income generate a slight increase in the portfolio’s Sharpe ratio, driven by an increase in returns. In both cases, the addition of a lowly correlated source of returns enhances portfolio diversification.

Exhibit 7: HYPOTHETICAL BENEFIT OF ADDING AN EQUITY MARKET NEUTRAL ALLOCATIONTO A TRADITIONAL PORTFOLIO

January 1990 to June 2018 


Source: StyleAdvisor and QS Investors.
Returns and volatility are annualized. The proxy for US Equity is the S&P 500. The proxy for US Fixed Income is the Bloomberg Barclays US Aggregate Index. The proxy for Market Neutral is the HFRI Equity Market Neutral Index. Please refer to Important Information on Hypothetical Performance at the end of this document.

In sum, equity market neutral strategies offer a compelling opportunity for investors seeking to reign in their risk exposure as the current market cycle may be coming to an end. With virtually little-to-no correlation to equity, fixed income and other asset classes, equity market neutral can help mitigate some of the risks likely to materialize as we move into the later stages of the current expansion cycle, and amid expectations of rising interest rates. The potential diversification benefits of adding an allocation to equity market neutral are worth due diligence efforts in this space.

1 Periods of rising interest rates are defined as periods in which the US 10-year Treasury yield increased by at least 100 basis points, from trough
to peak. The periods include: September 1993 – November 1994, January 1996 – June 1996, October 1998 – January 2000, November 2001 –
April 2002, June 2003 – June 2004, June 2005 – June 2006, December 2008 – June 2009, October 2010 – February 2011, July 2012 –
December 2013, July 2016 – December 2016, and September 2017 – June 2018. Periods of falling interest rates are defined as periods in which
the US 10-year Treasury yield decreased by at least 100 basis points, from peak to trough. The periods include: June 1991 – December 1991,
April 1992 – September 1992, December 1994 – December 1995, March 1997 – September 1998, February 2000 – October 2001, May 2002 –
September 2002, October 2008 – November 2008, March 2011 – August 2012 and December 2013 – July 2016. Periods of stable interest rates
are defined as periods in which there changes were smaller than 100 basis points.
2 Exhibit 6 does not include US Treasury Inflation-Indexed Securities as this asset class has a shorter time series available. For the period where
data on US Treasury Inflation-Indexed Securities is available, March 1997 to June 2018 period, the correlation between US Treasury Inflation-
Indexed Securities and: Equity Market Neutral was 0.04, US Large Cap Equities was 0.01, Developed ex-US Equities was 0.10, US Small Cap
Equities was -0.02, Emerging Market Equities was 0.15, US Fixed Income was 0.76, US Investment Grade Credit was 0.69, US High Yield Debt
was 0.28, Global Fixed Income was 0.64, Crude Oil was 0.16, and Gold was 0.41. Source: StyleAdvisor and QS Investors.

Data Table: proxies utilized to measure performance of different assets 

Asset
Proxy
Market Neutral Hedge Funds
HFRI EH: Equity Market Neutral Index
US Equity
S&P 500
Developed Market ex-US Equity
MSCI World Ex. US Index
US Small Cap Equity
Russell 2000
Emerging Market Equity
MSCI EM (Emerging Markets)
US Fixed Income
Bloomberg Barclays US Aggregate
US Investment Grade Credit
Bloomberg Barclays US Corporate Investment Grade
US High Yield Debt
Bloomberg Barclays US Corporate High Yield
Global Fixed Income
Bloomberg Barclays Global Aggregate
Crude Oil
S&P GSCI Crude Oil
Gold
S&P GSCI Gold
Inflation Protected US Bonds
Bloomberg Barclays US TIPS


IMPORTANT INFORMATION
The strategy outlined is not currently offered and as such, no clients are invested in this strategy. It is purely hypothetical and the performance returns and other statistics were calculated by QS Investors using published data sources, which have been noted throughout this paper.
This material is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or QS Investors, LLC to enter into or arrange any type of transaction as a consequence of any information contained herein. QS Investors, LLC does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of QS Investors, LLC, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person.
The views expressed in this document constitute QS Investors’ judgment at the time of issue and are subject to change. Past performance or any prediction or forecast is not indicative of future results. Investments are subject to risks, including possible loss of principal amount invested.

HYPOTHETICAL PERFORMANCE
Hypothetical performance results are inherently limited and should not be relied upon as indicators of future performance. The hypothetical returns do not represent actual recommendations or trading, and may not reflect material economic and market factors. The results presented should not be considered a substitute for the investment performance of an actual portfolio. No representation is made that any account will or is likely to achieve returns similar to those presented. The hypothetical returns are unaudited. Past performance is not indicative of future results; current hypothetical performance may differ from that shown in this presentation.

QSCR 18248 (September 2018)

How Can QS Help?

Related Investment Vehicles:

  • Legg Mason Alternative Completion Portfolios
  • QS Global Market Neutral Fund

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