Key takeaways:
- Alternative diversifiers can strengthen portfolios without reducing equity exposure.
- Actively managed long-volatility strategies can reduce costs by optimizing exposure timing and selecting efficient instruments. In trend-following, a multi-manager approach is preferred.
- Systematic rebalancing can provide additional benefits.
On March 11, Russell Investments hosted a webinar examining the challenges and opportunities presented by alternative diversifiers, including strategies for incorporating these solutions into portfolios.
The discussion featured insights from a panel of Russell Investments experts: Amneet Singh, director of asset allocation strategy; Cedric Fan, senior director and head of hedge funds; and Mark Raskopf, hedge funds portfolio manager. Also joining the discussion was Patrick Kazley, head of solutions at One River Asset Management.
Below is a summary of their conversation.
High valuations
The discussion began with an analysis of current equity market valuations by Kazley. He noted that equity returns today are in the 97th percentile of rolling 10-year averages, meaning they have performed exceptionally well. While this suggests caution, history shows that high valuations do not necessarily imply imminent declines. Instead of reducing equity exposure, the panel advocated for a "barbell approach"—maintaining strong equity allocations while using diversifiers to mitigate risk.
Traditional risk mitigation strategies
Fan noted that institutions often rely on bonds to hedge against equity downturns. However, the effectiveness of this approach has diminished in recent years, especially in inflationary environments like today’s where stocks and bonds may move in tandem. The panel highlighted that 2022 was a stark example of this, when many 60/40 portfolios suffered drawdowns comparable to those seen in the Global Financial Crisis.
Alternative diversifiers
To address the shortcomings of traditional hedging, the panel introduced an alternative approach based on:
- Long volatility (Long Vol): Strategies that gain value during periods of market turbulence.
- Cross-asset trend following: Strategies that dynamically allocate to asset classes that are performing well while reducing exposure to underperforming ones.
Both strategies offer structural diversification benefits, meaning they are inherently uncorrelated with equities rather than relying on macroeconomic conditions to perform well.
Why these strategies can work
Singh explained that long volatility strategies act as a fast-twitch defense, reacting quickly to sharp market shocks. Conversely, trend-following strategies are slow-twitch, protecting against prolonged downturns like 2022. Together, they provide complementary protection against different types of equity drawdowns.
Another advantage is cost efficiency. Active long-volatility management can reduce costs by selectively increasing exposure only when volatility is cheap. Trend-following strategies can also offset costs by capturing gains during sustained market movements.
Constructing the alternative diversifier portfolio
Through research, Russell Investments determined that an optimal mix could consist of a:
- 60% allocation to cross-asset trend
- 40% allocation to long volatility
This combination provides robust risk mitigation while maintaining capital efficiency. Additionally, these strategies are derivatives-based, meaning they hold significant cash balances, allowing investors to benefit from rising interest rates.
The role of active management
The panel emphasized that active management enhances these strategies:
- In long-volatility strategies, active managers can reduce costs by choosing the right volatility instruments and optimizing exposure timing.
- In trend-following, a multi-manager approach is preferred, as no single manager consistently outperforms across all market conditions.
Implementation via overlays
Fan stressed that institutions should not reduce equity exposure but rather overlay these diversifiers to maintain their long-term asset allocation. The key benefit of the alternative diversifier approach is its ability to generate gains in downturns, which can then be systematically reallocated to equities when they are undervalued. This systematic rebalancing provides additional return enhancement.
Demonstrating the rebalancing effect
Kazley illustrated the power of rebalancing through a simulation. By maintaining a 20% allocation to the alternative diversifier and systematically rebalancing gains into equities, an investor could have generated an additional 85% return over a 17-year period. This "rebalancing alpha" stems from the simple mathematical benefit of reinvesting during market downturns.
Potential risks and drawbacks
Despite its potential strengths, the panelists noted that an alternative diversifier strategy is not without risks. The primary downside scenario occurs when trend-following strategies fail to offset the cost of long-volatility exposure. Historically, this has happened during range-bound markets with low volatility, such as 2011. However, over long-term investment horizons, the combination of long-volatility and trend-following has been shown to provide positive returns while maintaining diversification benefits.
The bottom line
The panelists stressed that an alternative diversifier approach can be an effective solution in today’s environment. By combining trend-following and long-volatility strategies, institutional investors can potentially strengthen the resilience of their portfolios without sacrificing equity exposure.