In the commodities space, energy and industrial metals (which can be driven by market-specific supply/demand factors) can provide an inflation hedge, though lately metals have behaved unhappily, similar to emerging markets.
Elsewhere, some hedge funds have a demonstrable history of generating uncorrelated active returns through trading more niche markets such as volatility futures and energy contracts. Investors could also consider a hedge fund cohort we can describe as ‘volatility winners’ – designed to swiftly change positioning as market trends change direction, potentially benefiting as market volatility rises.
These types of systematic trading strategies can also offer something different to the path of public asset markets and so could play an important role in portfolios.
Alternative assets can also provide investors with valuable portfolio protection. Again, diversification is crucial – no two market cycles are ever the same and assets that may have offered diversification during stress periods in the past may not do so in the future.
For example, gold has traditionally proven useful as a portfolio diversifier, and precious metals should fare well if another financial crisis develops or geopolitical shock occurs. Gold’s glaring vulnerability, though, is that it can struggle when the US dollar rallies, and/or if US Treasury yields rise (though even these hindrances can be superseded when risk aversion spikes).
Non-traditional alternative assets can play a protective role too. These include ‘left-tail’ protection strategies, which aim to help offset potential sharp falls in riskier asset classes.
It is no secret that financial markets can be prone to sharp, unexpected corrections, and while such corrections are not always followed by recessions, the initial trigger is generally not foreseeable (i.e. a ‘black swan’ event).
Left-tail protection strategies actively seek to position themselves to increase in value during these rare, extreme market moves while most other traditional asset classes are suffering. Though no return is truly guaranteed, these strategies (built via options and other derivatives) offer payoffs in the event of extreme market moves but come at a cost to portfolios during benign periods – much like insurance policies.
As one potential way to limit losses, these strategies can allow investors to keep risk (and thus the chances of reward) on the table for longer in challenging market conditions.
However, investors must think carefully about balancing the cost of these strategies during benign periods against their potential payoff during extreme downturns. However, on the basis that these strategies improve convexity in portfolios (i.e. their return expectations accelerate as the size of the market move increases) they can offer vital protection to the right portfolios.
Understanding risks as well as rewards: using alternative assets carefully
