Alternative Strategies During Rate Cut Cycles

With additional content provided by Michael McClain, AVP, Research.

Historical Performance

As the Federal Reserve (Fed) embarks on what the market is suggesting will be a series of interest rate cuts through year end and after, for those with exposure to alternative investment strategies, the question becomes if investors should reconsider or rebalance their underlying alternative sub-strategy exposure. During periods of rising rates and in general, higher interest rate regimes, alternative investment strategies benefit from an increase in dispersion and volatility; however, should we expect below-average returns as compared to their historical performance if the Fed is cutting interest rates?

The table below details how several alternative investment sub-strategies have performed in the 12 months following the past five rate-cutting cycles:

Source: LPL Financial Research, Factset, 1/1/1995–8/31/2024

For strategies with complete performance data across the five rate cut timeframes, during periods when the equity market declined following the initial rate cut (2001, 2007), all alternative strategies outperformed, with all four strategies delivering positive returns in 2001 and three of four doing the same in 2007. In 2007, Long/Short Equity managers, represented by the HFRI Equity Hedge Index, still provided strong downside protection with a loss of 5.0% as compared to a loss of 11.2% for the S&P 500. Also notable is the performance of the HFRI Systematic Diversified Index, which gained 4.1% and 17.0% during 2001 and 2007, outperforming the S&P 500 by 16.0% and 28.2%, respectively.

As compared to their historical average annual returns, Relative Value and Merger Arbitration funds have experienced marginally lower performance, on average, while Long/Short Equity and Trend-Followers, represented by HFRI Macro: Systematic Diversified, have outperformed their historical averages in the 12- months following the first rate cut. While performance for Discretionary Macro funds, as measured by the HFRI Macro: Discretionary Thematic Index, is limited to the 2019 and 2020 cuts, returns have been attractive given their ability to implement tactical views across markets and ahead of volatility caused by shifts in interest rate policies.

Source: LPL Financial Research, Factset, 1/1/1995–8/31/2024, HFRI Macro: Discretionary Thematic Index data begins 1/2008

When considering the investment styles and portfolio construction of each of these strategies, from a qualitative perspective, performance during these periods is consistent with expectations.

• Long/Short Equity — If volatility increases and the economy were to enter a recession, an increase in opportunities on both the long and short side may occur, leading to a more constructive environment for fundamental stock pickers. While Long/Short Equity is the most equity-sensitive strategy reviewed and will be more correlated with the equity market, the ability to profit from short positions that benefit from falling equity prices has historically added significant value and offset having a higher beta (greater market sensitivity) profile than other strategies.
• Systematic Macro /Trend-Following — These strategies capitalize on sustained price moves across equity, bond, commodity, and currency markets. Historically, long bond and short-equity positioning have supported returns when a rate cut cycle precedes a downturn. However, with lower interest rates, returns from collateral in these strategies are expected to be lower.
• Discretionary Macro — The ability of these strategies to tactically position portfolios across asset classes ahead of global Central Bank policy adjustments has historically led to attractive opportunities. This differs from Trend-Followers, who are dependent on market prices to first adjust before taking new positions on a lag following a shift in the prevailing trend.
• Relative Value — These strategies seek to exploit price discrepancies between related securities and deliver a more consistent risk-return profile over time. While the 12-month average index performance following the initial rate cut is slightly below long-term figures, index performance held up very well during 2001 and 2007 during steep equity market selloffs.
• Merger Arbitrage — Lower interest rates may lead to lower financing costs for acquirers, however, if the economy were to weaken, firms may also be less interested in any type of corporate transactions and focus more on internal operations.

Summary

While the sample size is rather small and as is always the case with alternative investment strategies - manager selection is paramount, however, more flexible strategies that can vary their long and short exposure have historically benefitted from rate-cutting cycles. While performance for Relative Value and Merger Arbitrage funds is slightly below historical averages, their returns post-rate cut is above that of the Bloomberg Aggregate Bond Index, which is a more appropriate benchmark given the similar volatility profile (all three have a historical annual volatility slightly above 4.0%). Overall, we continue to consider alternative investment strategies as attractive for suitable investors, regardless of the direction of interest rate, however, implementation and role in a diversified portfolio should be tailored for the best outcomes.