President Trump’s tariffs have driven market volatility, as measured by the VIX, to levels not seen since the pandemic. Currently, there is a temporary pause on the tariffs (aside from a 10% rate) for every nation except China, but that is not stopping the market from reeling as the world’s two largest economies push tariffs to nosebleed levels.
US Treasury securities have sold off, pushing down their prices and sending bond yields higher. As a result, the correlation between bonds and stocks has risen, leaving investors scrambling to find a place to take shelter.
Alternative investments, especially equity market neutral strategies, may be a useful bunker for investors in this global trade war. Equity market neutral strategies, if executed properly, have the potential to provide positive returns to investors without taking directional risk in the stock market.
In simple terms, equity market neutral managers buy stocks that they think could outperform (long positions) and sell borrowed stocks that may underperform (short positions). That means the potential risk and returns of this strategy tend to be predicated less on the general direction of the markets and more on the performance and positioning of their chosen securities.
Equity market neutral strategies did what they were supposed to when it mattered most.
For example, if all stocks decline in a broad-based selloff, managers can make money if their short positions decline further than their long positions. If the market recovers sending all stocks higher, managers can make money if their long positions increase in value more than their short positions. If some stocks increase in value and some decrease in value, managers can make money provided they selected the right stocks to hold long and short, on balance. Thus, it’s not necessarily the direction of the market but the performance of the underlying securities of the manager’s portfolio that matters.
Historically, this kind of approach has produced relatively low correlations to stocks and bonds and has had even lower correlations during major downturns such as the Dot Com bust and the Global Financial Crisis. In fact, during the Dot Com bust, equity market neutral strategies had a negative correlation to stocks. In other words, equity market neutral strategies did what they were supposed to when it mattered most.
Retail investors appear to have overlooked alternatives, including equity market neutral strategies, while institutional clients have seen their benefits for decades. Morningstar data suggests that less than 1% of total mutual fund assets are in alternatives. This indicates that advisors have an opportunity here to shed light on this asset class and explain to their retail clients how equity market neutral strategies could, potentially, offer a haven from volatility.
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