As Equity Markets Normalize, Alternative Strategies May Be Worth Considering

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Includes: CPNAX, GLTAX, GMSDX, LSQAX, LSTAX, MKNAX
by: Invesco US

Summary

I believe it may be prudent for investors to, at a minimum, prepare for a normalization of equity returns and risk.

As the equity market normalizes, I believe alternative investments can be helpful to investors. That’s because alternatives have a history of outperforming equities during periods of stock market weakness.

In such environments, I believe investors should consider — market neutral, global investing and trading, long/short equity strategies — as a way to potentially reduce the effects of equity volatility.

Explore three strategies that may help investors reduce volatility in their portfolios

By Walter Davis, Alternatives Investment Strategist. Posted on Expert Investment Views: Invesco US Blog.

I discussed in a recent blog post how it might be prudent for investors to brace for the normalization of equity returns and risk - that is, when equity returns decline from recently high levels, risk increases from recently low levels, and they both perform more in line with their long-term historical averages.

Right after that blog posted, we experienced a sharp equity sell-off and a spike in volatility.

As the equity market normalizes, I believe alternative investments can be helpful to investors. That's because alternatives have a history of outperforming equities during periods of stock market weakness, as the chart below demonstrates.

alternative investments during market cycles

The period represented is January 1997 through June 2015. Past performance is not a guarantee of future results.

Invesco believes that to reach their goals, investors should make alternatives a core part of their portfolios. But which alternatives? In times like these, I believe investors should consider the following strategies as a way to potentially reduce the effects of equity volatility in their portfolio.

Market neutral strategies - Market neutral funds trade related equities1 on a long and short basis - to the point where the fund has close to a zero beta2 and close to zero net market exposure. With market neutral strategies, the key to generating a positive return is security selection - that is, determining which equities to go long on and which to go short.

Given their lack of beta and net market exposure, market neutral funds tend to be insulated against market swings, have the potential to generate positive returns in all market environments and typically produce returns that have low correlation to stocks and bonds. Furthermore, market neutral funds tend to generate modest returns with low volatility, similar to the historical risk-return profile of bonds.

Investment ideas - I believe advisors seeking to insulate their clients' portfolios against heightened volatility should consider market neutral funds. Invesco Global Market Neutral Fund (MUTF:MKNAX) is an example of typical market neutral fund, while Invesco All Cap Market Neutral Fund (MUTF:CPNAX) is an example of a more aggressive version (i.e., it seeks higher returns with higher risk).

Global investing and trading strategies - Global investing and trading strategies invest opportunistically on a long and short basis across the global equity, fixed income, currency and commodity markets. Global macro and managed futures are the two most common examples of this strategy. These funds have the ability to trade opportunistically, selecting which markets they want, and don't want, to participate in. Furthermore, because these funds have the ability to invest on both a long and short basis, they have the potential to achieve profits in both rising and falling market environments. Both global macro and managed futures funds have historically done well during periods of heightened market volatility and have historically generated returns with low correlation to stocks and bonds.

Investment ideas - Advisors should consider this strategy if they are looking to add investments to their clients' portfolios that have the ability to benefit from heightened volatility, can opportunistically trade the global markets and have the potential to profit in both rising and falling markets. Invesco Global Targeted Returns Fund (MUTF:GLTAX) and Invesco Global Markets Strategy Fund (MUTF:GMSDX) are examples of global macro funds.

Long/short equity - Long/short equity funds combine both long and short equity positions in a portfolio, while typically being net long to stocks. As a result, these funds have a positive beta to stocks, and their performance tends to directionally follow the equity market. In general, such funds would be expected to underperform stocks during a rising equity market (due to losses on the fund's short equity positions), and outperform stocks during a falling equity market (due to gains on the fund's short equity positions).

Two key differentiators across long/short equity funds are how they implement their short positions and their typical net exposure to the market. For example, some funds use indexes for their shorts, while some will short stocks they think will decline in value. A manager with expertise in shorting can potentially add considerable value by playing offense with the short portion of the portfolio. That's because those managers seek to generate positive returns from their short positions rather than using shorts solely for hedging purposes. The level of net market exposure can vary greatly from manager to manager, and is something that an advisor should understand before investing.

Investment ideas - Advisors concerned about the direction of the equity market should consider replacing some of their long-only equity exposure with exposure to long/short equity. By doing so, advisors can help their clients maintain net long exposure to the equity markets, while gaining potential downside protection. Invesco Long/Short Equity Fund (MUTF:LSQAX) and Invesco Macro Long/Short Fund (MUTF:LSTAX) are examples of long/short funds.

Important information

  1. Stocks are related if they are driven by the same fundamental factors, for example, two stocks from the same industry.
  2. Beta is a measure of the volatility of an equity in comparison to the equity market as a whole.

Diversification does not guarantee a profit or eliminate the risk of loss.

Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.

Alternative investment products, including hedge funds and private equity, involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. There is often no secondary market for an investor's interest in alternative investments, and none is expected to develop. There may be restrictions on transferring interests in any alternative investment.

Before investing, investors should carefully read the prospectus/summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the Funds visit invescopowershares.com for prospectus/summary prospectus.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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As equity markets normalize, alternative strategies may be worth considering by Invesco US Blog