Add alpha components to portfolio in preparation for rising interest rates

“You're gonna need a bigger boat …”

Roy Scheider, in “Jaws,” 1975

For me, Roy Scheider's famous line allegorically brings to mind the current state of the markets. While risk assets continue to rally, investors — much like their beleaguered counterparts from the fictional island of Amity — remain cautious, and indeed might be looking for a bigger, or at the very least a better, boat. Perhaps they seek a craft more suitably constructed to withstand the many macro risks circling just under the deceptively calm market waters — I certainly would.

While the market remains relatively tranquil on the surface, there is an increasing sense of trepidation — or uncertainty — related to potential threats lurking below. Macroeconomic concerns, including geopolitical hot spots, China's status and whether global GDP growth can be sustained, all pose legitimate problems for market stability.

Perhaps the most significant and pressing concern today, however, and certainly one the majority of market observers are keenly focused on, is the threat of rising interest rates in the U.S. … cue the John Williams score. Given the current market environment, particularly as it relates to fixed-income securities, rising interest rates could represent a metaphorical great white macro risk for portfolios not suitably positioned. “You know the thing about a shark, he's got … lifeless eyes, black eyes, like a doll's eye. When he comes at ya, doesn't seem to be livin'. Until he bites ya and those black eyes roll over white.” Indeed, when rising interest rates eventually do bite, some investors eyes might roll over white as well. Fortunately, the story does not have to end there, despite the fact a rise in rates is seen as an eventual certainty. There does exist a better boat, one constructed not only of equity beta and bond beta, but one built using a good amount of alpha also. I believe this alpha boat might fare quite well in a rising rate environment, perhaps even prosper.

I want to highlight the relationship I see between alpha and interest rates, and why in my view a portfolio constructed with alpha components is perhaps the best-suited vehicle to withstand the inevitable rate rise when it surfaces. I also want to make several other points with regard to alpha.

Alpha is a measurable and tangible market byproduct. It is the noise inefficiency residual that shadows the market signal, and it creates a value “song” that can be captured and appreciated by market participants with discerning ears … and the right equipment. In this way I like to consider alpha as a viable investment, a security in its own right. We are comfortable with beta as an investment, why not alpha? As illustrated in Exhibit A, we see the average for alpha over the past 20 years, as measured by the Hedge Fund Research Index Fund Weighted Composite vs. the Standard & Poor's 500 index, has been 5.99%.

The second observation I would like to make relates to alpha and its cyclical nature. Alpha, like many other aspects of the market, is a cyclical phenomenon that waxes and wanes with macro environments, demographics and investor behaviors. The amount of alpha captured has historically been stronger on average in some regimes, such as periods with higher interest rates, and weaker in other regimes.

In Exhibit B, we can see the cyclical behavior of alpha graphically displayed.

My last point relates to alpha and the strong relationship I observe it having with interest rates.

First and foremost, we should note that most financial market observers believe the U.S. Federal Reserve will start to hike interest rates at some point in the not too distant future, perhaps as early as the second half of 2015. Fixed income has enjoyed a bull market rally spanning close to 30 years now, give or take a few outliers such as 1994. Interest rates have steadily declined from the midteens in the late 1970s to single digits today. This inexorable decline — and associated increase in bond prices — has protected investors against rate and duration risk for an extended period. But it seems inevitable that this long-term trend of lower rates and higher bond prices will reverse, and not preparing for this shift appropriately will leave some boats taking on substantial water.

Given this, we see many institutions seeking to mitigate these risks by looking to alternative strategies, like hedge funds, where customized portfolios can be structured that seek to soften interest rate and duration exposure. These fixed-income “surrogates” can be particularly attractive in a rising rate environment because they can be structured to both provide protection and gain from rising rates.

In my view, when interest rates go up bonds will naturally suffer some, equities will probably do OK, but the real strength will be in alpha-generating strategies like hedge funds. Statistical analysis of the historical relationship between interest rates and alpha supports this. In Exhibit C, we have created a factor response curve that illustrates the historic relationship between HFRI FWC alpha levels and U.S. five-year Treasury yield levels. As you can see, when interest rate level averages over the past 23 years have been at their lowest, represented by the first quintile bar on the left, average alpha levels also have been at their lowest. But as we move from lower yield levels to higher average levels across the five quintiles, we see a corresponding rise in average alpha as well.

Clearly, higher nominal yields of U.S. government bonds, such as five-year Treasuries, have on average historically corresponded with increased average annualized hedge fund alpha capture as well. In my experience, the vast majority of hedge funds are in fact defensive with respect to interest rate risk, while some macro managers see it as a speculative opportunity.

Conceptually, I find that the relationship between rising rates and the associated increase in the level of alpha capture to be quite intuitive. Imagine a street with several homes on it, all built by the same contractor and all the same value. The occupants of these homes, particularly in a very low-rate environment, might represent a broad range of economic backgrounds. When interest rates are low, the ratio of income to monthly payments is manageable for all. For the wealthy families, it is likely not even recognized economically, while for the lower-income group it might represent a significant component of their economic circumstance, but it is still sustainable. As rates rise, however, the lower-income families will feel increased pressure, and some might eventually be forced to sell their homes for non-rational economic reasons. Alternatively, the wealthy families will not feel added economic pressure from the rise in rates, and in fact they might benefit from personal investments and savings that potentially gain from increased yields.

A similar dynamic occurs for companies and countries when rates rise. The result is a pressure on profit margins, and the variances in profit margin pressures are reflected in the variance in security performance. The inefficiencies created by these variances promote alpha.

In closing, the implication of rising rates for individual and institutional portfolios, particularly for fixed-income investments, could be troublesome as they will be confronted with either diminishing returns with small losses or potentially significant losses — depending upon the magnitude and velocity of the rate rise. We believe an alpha boat is the best option available to hedge against the eventual attack.

Brooks Ritchey is senior vice president, Franklin Templeton Solutions, K2 Advisors LLC, Stamford, Conn.