Alternative income under the microscope
SCOTT KEFER, CFA 21-Mar-2021
Alternative income funds are having a moment. It’s easy to see why.
Sure, the economy and financial assets have staged a remarkable recovery since the early days of the pandemic, but at what cost? Previously unheard-of amounts of monetary and fiscal stimulus have been unleashed—not just in the U.S. but globally. For the most part, this torrent of liquidity has had the desired effect. People are going back to work and, vaccine efficacy willing, it appears that we are moving toward the end game of this pandemic, or at the very least a new normal.
But now what? The federal funds (fed funds) target rate has been set at near zero (a range of 0.0 to .25%); however, the yield on the 10-Year Treasury has rallied sharply recently. Consider that back in early August 2020, the yield was approximately 0.50, but less than nine months later it was 1.6% (as of mid-March). That type of sharp move higher has worried investors since it puts the principal of their “safe” bond portfolio in jeopardy.
On top of that, the massive fiscal response is conjuring up legitimate longer-term concerns, and investors are asking some tough questions: Are we embarking on a new era of rising inflation? Will yields continue to spike higher? Is the four-decade bull market in bonds over? And have equities gone too far too fast, setting up for a correction?
While nobody definitively knows the answers to these questions, investors are right to consider how they should reposition amid the looming challenges. This is exactly why alternative income funds are gaining traction. Indeed, investors are looking for strategies that check off several key boxes:
1. Attractive income from non-traditional sources—to help manage duration and minimize risk to rising rates.
2. Relatively low levels of volatility—with risk profiles similar to traditional bonds.
3. Low correlation to bonds—in the event inflation returns and rates head higher.
4. Low correlation to stocks—in the event that there’s another episodic drop in equities.
Many alternative income strategies, by their nature, are more sophisticated and often seek income from equity securities (rather than bond interest income). Since equity investments are inherently riskier than bond investments, alternative income strategies usually attempt to counter or “hedge” the extra risk with derivatives and/or by short selling securities. Of course, as with any sophisticated strategy it’s critical to understand the differences among alternative income funds. For starters, capturing equity dividends may be an appealing supplement to traditional fixed income, but investors need to understand if and how any strategy offsets the equity risk. Is the hedge done using liquid instruments that are widely available in various market conditions? Or Is this hedge done through an active manager’s arbitrary pairing of long and short individual equity positions? That might be a red flag.
We believe that the best strategies avoid managing equity risk by shorting individual stocks, which in turn may open the fund up to the vagaries of the options market and/or the risk of a “short squeeze.” A more prudent approach may be to de-risk (i.e. hedge) through a transparent and systemic process using broad market index futures contracts. A rules-based approach using the most liquid securities seems preferable.
This may appear like a small difference–a nuance even–but in any strategy that employs hedging, the details matter. So, while investors are right to consider alternative sources of income today, they should be mindful of how exactly a fund is offsetting its equity risk.
One final point to consider before choosing to allocate to an alternative income strategy is to understand how such an allocation may affect your overall risk budget. In other words, don’t stretch for income and inadvertently pile on the equity risk. Be certain you are funding the new allocation from similar or higher-risk assets.