Investing in a Rising-Rate Environment

Darren Wolf, CFA

With the U.S. economy continuing to show incremental signs of a recovery, and the Federal Reserve scaling back or “tapering” the injection of capital into the bond market, the prospect of rising interest rates is becoming more of a reality. Investors of all types would be wise to assess their interest rate risk in advance of continued monetary tightening by the Fed and consider how they may want to reposition their portfolios.

Here at Arden we believe that alternative investments, particularly ones comprised of hedge funds with a  variety of strategies, can provide a safe harbor during most rising rate environments. Historically, funds of hedge funds have posted higher returns during quarters when interest rates were rising.

Since 1991, the HFRI Fund of Funds Composite Index has had a modestly positive relationship to both short-term (T-bills) and long-term (10 year) rising yields. There are several possible explanations for this trend. First, diversified fund of funds tend to have limited exposure to longer duration assets. Funds that do take sizable positions in rate-sensitive credit markets will often opportunistically hedge that rate exposure. Second, arbitrage spreads and other relative-value strategies used by some hedge fund managers benefit from rising rates.

Here’s why: many relative value and arbitrage spread relationships are effectively “time arbitrage” strategies, whereby a hedge fund manager is awaiting an event or catalyst to be realized to compress the spread (merger arbitrage, for example). Embedded in the arbitrage spread is a discount rate, accounting for the time remaining until the deal closes or the event concludes. That rate is in part derived from the absolute level of interest rates; higher absolute levels of interest rates lead to higher arbitrage spreads. Certainly other factors also contribute to the aggregate spread (fundamental factors, technical factors, anti-trust, etc), but interest rates are a critical component.

Granted, rising rates have not always been positive for alternative, multi-manager portfolios. In the early 1990s, the Federal Reserve kept rates at 3 percent to allow the financial industry to recover from the S&L scandal. When the Fed started to tighten monetary policy in early 1994 into 1995, the HFRI Fund of Funds Composite Index declined by almost 6 percent. While a repeat of 1994 is possible, the evidence shows that the Federal Reserve has since become more transparent in its monetary policy decisions, and therefore is much less likely to surprise markets.

In the current environment, an uptick in inflation will likely be a key driver behind a rise in rates. We think hedge fund managers are well positioned for a rate-rising/inflationary environment. Unlike a traditional long-only stock fund, alternative funds by their very nature are a collection of long and short exposures. If inflation hits, we foresee hedge funds using the flexible nature of their balance sheets to increase the size of their hedges and/or decrease long exposures. Different industries and companies will adapt with varying degrees of success to this new higher-rate environment, providing opportunity for stock pickers as well as short sellers. We also think that an inflationary environment will lead to even higher levels of corporate restructuring and deal making, benefiting managers who use event-driven strategies.

All investing poses some risk, but we also feel that the traditional portfolio combination of stocks and bonds is particularly vulnerable to rising rates at this point in history. Equity markets are at an all-time high, while the downward trend in bond yields over the last 20 years means that the ability of fixed-income to provide protection no longer exists. We believe that investments with low correlation to these markets, or hedge fund strategies with the ability to trade from both long and short sides of the portfolio, can provide true diversification, especially for short to medium term investors.

Darren Wolf, CFA, is the Director of Research at Arden Asset Management.



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