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How to Use Alternative Investment Strategies
12/26/2011 10:00 am EST
Focus: ALTERNATIVE INVESTMENTS
Currencies, commodities, and managed futures can be part of a portfolio that complements more traditional equities. Direxion Funds’ Ed Egilinsky describes why alternative investments are a good idea when it comes to assets with a long-term record of showing positive returns during equity bear markets.
Kate Stalter: Today our subject on the Daily Guru is alternative investing. We’re talking with Ed Egilinsky, head of alternatives at Direxion Funds.
Ed, obviously the equity markets have just been insanely volatile and frustrating for a lot of investors. Tell us about your big-picture definition of alternative strategies.
Ed Egilinsky: We at Direxion view alternative investments as anything outside of long-only stocks, bonds, and cash.
What that means is looking for different types of alternative strategies that don’t necessary correlate or relate to stocks and bonds, and have somewhat of an independent return stream—meaning they have the ability to perform in an equity bear market or a higher interest-rate environment, which might be adverse to fixed-income clients.
- Also read: Using Alternatives to Ease Volatility
Really, when you’re looking at alternatives in general, the reason that most clients are looking at these types of investments first and foremost is to try and help mitigate risk. Contrary to what most people think when they hear alternatives, when you blend most different types of alternatives into a stock and bond portfolio, it tends to mitigate the risk of the overall portfolio and potentially enhance the return.
Kate Stalter: One of the things that has really frustrated a lot of investors recently has been this high degree of correlation across various asset classes. Have you seen that at all, with regard to any of the alternatives?
Ed Egilinsky: When you look at this year, especially in the second half of the year, you’ve seen a higher degree of correlation with some alternative strategies, relative to the broader equity market.
But when you look at it from a longer-term perspective and take different bear markets in equities that have occurred over the last ten-plus years—2001 for example, or 2008—a lot of alternative strategies—managed futures, long-flat commodity strategies, long/short currency strategies—have actually have shown positive returns during those periods of time.
Kate Stalter: Let’s talk a little about some of the specific instruments from the Direxion family that would address some of this interest in alternatives.
Ed Egilinsky: Well we have a number of alternative strategies that a retail client can get access to in a daily liquidity vehicle. A couple of them are currencies. We have a long/short currency index strategy. It’s to my knowledge the only index currency strategy that can take advantage of whether prices are rising or falling versus the US dollar.
We have a commodity strategy that can take advantage of price movements, whether commodities are rising or falling. Most investors that have exposure to commodities tend to only benefit if commodity prices rise. So we have a strategy with our commodities that could potentially profit regardless of the direction of the commodity markets.
Commodities, of course, at times can have major declines to them even when they’re in a bull-market cycle. To have a strategy that can be a little more nimble and take advantage of those directional price trends regardless of direction is a big advantage in most cases.
Also, managed futures. Managed futures is an asset class that looks to take advantage of price trends regardless of direction. It involves areas like commodities, energies, metals, grains, as well as financial instruments—areas like interest rates and currencies.
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Historically, managed futures, when you look at broader benchmarks that represent the managed futures space, such as the Barclay CTA Index, the CISDM [Center for International Securities and Derivatives Markets] fund pool index, they have shown the ability to perform during major bear markets in equities over the last 30-plus years.
One of the reasons that managed futures as an asset class has been able to show positive returns during those periods is because usually bear markets in equities are caused by some extraneous event, whether it’s political, economic, social. As a result of that, it tends to create volatility, directional volatility, which managed futures and other long/short, long-flat strategies can take advantage of.
Kate Stalter: Ed, I wanted to ask you about using alternatives instead of blue chip dividend stocks. The reason I’m asking you that is, a lot of advisors that I talk to that primarily have a long-only strategy are putting clients into blue chips with high dividend yields. What’s your opinion of that phenomenon?
Ed Egilinsky: Well, I look at the high-dividend-yielding type of equity strategies as being different than alternative strategies. When you look at equities, whether they’re dividend paying stocks or not, they’re going to tend to move more in lockstep with the broader equity markets, albeit that they might be a little more conservative in nature, some of those stocks that pay a higher dividend.
When you look at it though, it’s still equity exposure. I look at what we’ve just discussed in terms of different alternative strategies—currencies, commodities, managed futures—truly unrelated to the equity markets.
A good complement to a portfolio of equities and fixed income, including equities, that provides some dividend income for clients. So I think when you look at alternatives, you have to look at it as a complement to stock and bond exposure, whether it’s dividend paying stocks or equities in general.
Kate Stalter: Ed, that segues into the last question I had for you today: Just how some of these alternatives should be used in conjunction with a traditional equity portfolio. Any specific balance that you advise?
Ed Egilinsky: Well, what we’ve seen is a lot of investment firms and clients are looking at anywhere between from 10% to 30% of their total portfolio in different types of alternative strategies.
One of the reasons that institutions have participated in alternatives for decades is really to mitigate risk, capital preservation. They also use different types of alternative strategies because they don’t only not correlate to stocks and bonds, but they also have a low correlation to each other, making the case of owning multiple alternative strategies, such as currencies, commodities, managed futures within one portfolio.
When you look at the allocation range, why we say 10% is because at those levels we feel it’ll have an impact on the overall portfolio. If you have a smaller allocation—less than 10% to alternatives—it’s good from a diversification standpoint, but it’s not going to have as much of a meaningful impact on the overall portfolio’s risk and return.
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