Speed Limits: Managing Risk and Return
In the 1980s and 1990s, any mention of the term “hedge fund”2 was liable to conjure images of reckless, Maserati-driving money managers among investors. Today, this typecast may continue to skew how many investors perceive alternative investments.3
It’s true that many alternative investment strategies are created with the aim of providing better returns per unit of risk taken. In other words, they try to get the most “bang for the buck” in investment terms. It’s also true that like other investments, alternative strategies charge investor fees and include risk of loss. However, while they can be more risky than other investments, many of today’s alternative strategies are designed with the goal of managing risk and return more strategically. For example, implicit in some alternative strategies is the idea that potential returns can only be considered “good” if the level of risk to get to that potential return is not too high. Many alternative strategies also have the capacity to offer enhanced portfolio diversification, which can also help mitigate equity risk. No investment strategy or risk mitigation technique can eliminate risk in full.
A little historical context helps to describe how hedge funds can be designed as risk-aware strategies far less analogous to runaway sports cars. The first hedge fund was created in 1949 by Alfred Winslow Jones, a famously reclusive Australian sociologist. At that time, many investors felt that they had no choice but to let the ups and downs of the market run them over. By contrast, Jones wanted to try to better control for market movements with measures to manage risk. The result was the first long/short hedge fund6 – an investment strategy intended to better manage equity risk, provide better risk-adjusted returns, and attempt to maintain some level of control over a turbulent market.
Helping to Manage Market Anxiety
Many investors fear large equity losses during market crisis events, such as the tech bubble or the global financial crisis. In fact, 80% of women investors we surveyed in the US say they are concerned about short-term results.4 Crisis events sometimes shake an investor’s gut-check tolerance so severely that many investors quit the markets near the low and miss any asset class reversals. They may not dip their toe into equity markets for years. Managed futures5 is another asset class that, does not perform well in choppy markets or bull markets, may provide an offset to equity risk in the event of a market drawdown.
Some systematic, trend-following managed futures strategies are flexibly designed with the capacity to make both long and short6 equity investments. In other words, these strategies can buy equities they believe will increase in value (a “long” position7) or short sell8 equities they believe will decrease in value. By using asset classes that have the potential to move up when other risk assets are moving down, investors can be provided with another level of portfolio diversification and equity risk management. It is important to note that short positions involve the use of borrowed capital – and that both short positions and long positions involve substantial risk of loss.9 Investors should work with their financial professional to help determine what strategy might work best for them and understand the unique risks these types of investments are subject to.
Investing in a Rising Rate Environment
Other risks in the market surround the risk of bond prices when interest rates rise. Typically, as interest rates rise, bond prices fall and bond investors can lose money. Today, US interest rates sit near historical lows, which suggests there is only one eventual direction for bond yields – up. In an effort to mitigate this risk, some alternative strategies, like trend-following managed futures, seek to provide return and risk expectations that fall in between equity and bond return and risk expectations. These strategies may help displace bond price risk in a portfolio through the addition of alternative investments with similar risk and return profiles to bonds – with less interest rate risk. While such strategies involve risk, they can act like faux bond asset classes in a portfolio – potentially achieving comparable returns while mitigating risks related to rising rates.
Aligning Investment Strategies with Investment Preferences
Acknowledging that women may lean towards more portfolio protection, some alternative investment strategies can offer diverse potential to protect portfolios during extreme market crisis and buffer against interest rate risk. While being risk-aware might lead investors to believe that they are giving up returns, oftentimes a risk-alpha or “winning by not losing” philosophy can allow for better long-term portfolio growth. Of the women investors we surveyed in the US, 38% say they invest in alternative investments. However, 40% say their financial professional has not spoken to them about alternative strategies.9 As they work to build portfolios best suited to their investment preferences and financial goals, women investors could benefit from learning more about the potential benefits and risks of these investment approaches.
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All investing involves risk, including the risk of loss.
Diversification does not guarantee a profit or protect against a loss.
Alternative investments involve unique risks that may be different from those associated with traditional investments, including illiquidity and the potential for amplified losses or gains. Investors should fully understand the risks associated with any investment prior to investing. Hedge funds are unregistered private investment pools that are often illiquid and highly leveraged, and may engage in speculative investment practices. Hedge funds may be more volatile than investments in traditional securities and may not be suitable for all investors. Equity securities are volatile and can decline significantly in response to broad market and economic conditions. Bonds may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity. Futures and forward contracts, like other derivatives, can involve a high degree of risk and may result in unlimited losses. Because they depend on the performance of an underlying asset, they can be highly volatile and are subject to market, credit, and counterparty risks. Managed futures use derivatives, primarily futures and forward contracts, which generally have implied leverage (a small amount of money used to make an investment of greater economic value). Because of this characteristic, managed futures strategies may magnify any gains or losses experienced by the markets they are exposed to. Managed futures are highly speculative and are not suitable for all investors. Short selling is speculative in nature and involves the risk of a theoretically unlimited increase in the market price of the security that can, in turn, result in an inability to cover the short position and a theoretically unlimited loss. Derivatives may involve more than the risk of loss of capital.
2 Hedge funds are alternative investments that use pooled investor assets to employ different strategies in the attempt to earn a return for those investors. An alternative investment is an asset that is not one of the conventional investment types, such as stocks, bonds, and cash. Alternative investments involve risk of loss.
3 An alternative investment is an asset that is not one of the conventional investment types, such as stocks, bonds, and cash.
4 Natixis Investment Managers, Global Survey of Individual Investors conducted by CoreData Research, February-March 2017. Survey included 8,300 investors from 26 countries, of whom 750 are US investors. Of the 750, 351 are females.
5 A managed futures account is a type of alternative investment in which trading in the futures markets is managed by another person or entity, rather than the account’s owner. Futures are an agreement to buy or sell a particular commodity or security at a predetermined price in the future.
6 Long/short equity is an investment strategy generally associated with hedge funds involving the purchase of long equities that have the potential to increase in value and the selling of short equities that have the potential to decrease in value.
7 A long position refers to the purchase of a security with the expectation that the asset will rise in value.
8 A short position refers to the sale of a borrowed security with the expectation that the asset will fall in value.
9 Natixis Investment Managers, Global Survey of Individual Investors conducted by CoreData Research, February-March 2017. Survey included 8,300 investors from 26 countries. 750 investors are from the US, of whom 506 are advised investors.