A Nod to the Windward Side: Liquid Alts and Volatile Markets
A market correction is generally considered a decline of 10% in the broad averages (the Dow Jones Industrial Average, the S&P 500); a bear market is said to begin when the drop hits 20%. What the markets have experienced year-to-date is clearly a correction, with both the major averages down slightly more than 10%, as of February 8. Whether or not this will turn into a bear market is anyone’s guess, but it’s hard to argue that one isn’t due after a nine-year bull run.
Corrections are common, and on average, last around four months and knock about 13% off the markets, according to Goldman Sachs. Historically, bear markets come along about every 3.5 years, and last about a year. In the year following the last three 20%+ declines in the S&P 500, the index gained an average of 32%. But, no one has yet come up with a formula to reliably predict any of this.1 To repeat a couple of well-worn Wall Street bromides: market timing has never been proven to work, and volatility is not the same as risk.
Still, these market gyrations can be unnerving. As we’ve noted before, volatility can effectively become risk when you try to time the market. There are lots of examples why this isn’t a good idea. Take the period 1995 – 2014, which included both the Dot Com Crash and the Financial Crisis. Let’s say that an investor fully invested in the S&P 500 throughout that period would have had a 9.85% annualized return. Not bad. But, had he or she missed the 10 best days over that 20-year period, the annualized return would have dropped to 6.1%. In dollar terms, $10,000 compounding at 9.85% a year for 20 years would result in a return of $65,463; at 6.1%, the total return would be just $32,681, about half.2
But, of course, risk tolerance varies. Numerous studies have found that investor confidence – and self-reported tolerance for risk – rise in bull markets and decline in bear markets. Not hugely surprising, but if suitable, worth keeping in mind. Liquid alternatives can provide an attractive option across all kinds of markets – acting as an alternative diversified vehicle that may help manage volatility, while maintaining some exposure to equities during downturns, and providing some mitigation against downturns in periods of exuberance.
Market sentiment turns quickly, and so-called exogenous events can move stocks dramatically over the short term (a potential trade war, for example). Historically, the market tends to reward patience. In volatile times, liquid alts may be a viable investment vehicle to help stay the course.
1. Anspach, Dana. ‘U.S. Stock Bear Markets and their Subsequent Recoveries,’ Thebalance.com, February, 21 2018.
2. Ro, Sam. ‘How a few poorly-timed trades can torpedo two decades of healthy returns,’ Business Insider, March 12, 2015.
All investments are subject to market risk and will fluctuate in value. Past performance is not indicative of future results. An investment cannot be made in an index. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors, who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the federal government, as to the timely payment of principal and interest.
Liquidity risk is the risk that certain securities may be difficult or impossible to sell at the time that the seller would like or at the price that the seller believes the security is currently worth. The Fund may not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, unusually high volume of redemptions, or other reasons. To meet redemption requests, the Fund may be forced to sell securities at an unfavorable time and/or under unfavorable conditions.
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S&P 500 is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.
‘Compound Interest’ – Compound interest (or compounding interest) is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Thought to have originated in 17th-century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding; the higher the number of compounding periods, the greater the compound interest. Thus, the amount of compound interest accrued on $100 compounded at 10% annually will be lower than that on $100 compounded at 5% semi-annually over the same time period.
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