Alternative Investing: When a Hedge Is More than Just a Small Tree

Joan Alexandre, Investment Analyst II
September 15, 2017

As exists with the equity and fixed-income universe, there are many options when considering alternative investments: from venture capital to fine art. However, within capital markets’ murky corners, hedge funds have the most name recognition.

These much maligned and often misunderstood instruments can be solid additions to the traditional stock and bond portfolio. The key to their proper use is full understanding — not only of their purpose within the portfolio construction process but also their original intent.

The origins of hedge funds can be traced back to the 1920s1, but they did not gain wide adoption until 70 years later. They were initially structured as limited partnerships with the goal of providing downside protection for wealthy (accredited2) investors. This usually involved shorting stocks against a long-only equity portfolio. Over time, the marketplace for alternatives grew explosively, expanding to include retail investors, with the instrument’s purpose drifting from that of hedging market risk to chasing return.

Recently, reporting on financial markets has been rife with headlines decrying the terrible performance of alternative assets. However, if one takes a moment to consider their original purpose — that of creating an uncorrelated return profile vis-à-vis stocks and bonds — then many have performed exactly as designed.

Bookending the new millennium’s first decade were two massive destructions of wealth, the 2001–2002 tech bubble bursting and the 2008–2009 global financial crisis — a one-two punch that created a lost decade in stocks. While very few asset classes can act as bulwarks against the sudden stop of capital flows, in a normal market, volatility — even severe — can be mitigated with a diversified portfolio, which includes uncorrelated asset classes.

Below is a timeline of defining stock market events since 2000 that illustrates where the typical equity investor purchases or goes “all in” and where he sells or “cashes out.” Contrary to the old adage of “buying low and selling high,” investor behavior indicates the opposite is often true — perhaps because it is so frightening to buy low when the market is cloaked in uncertainty, while the fear of missing out makes it much easier to go all in when the herd is doing the same. This makes owning uncorrelated assets, such as alternatives, of paramount importance, as they can smooth the volatility beyond only diversifying within the same asset class.

Prior to the recent spike in volatility (as measured by the VIX), market turbulence had been largely absent, but a scene from the 2011 movie “Margin Call” reminds us when that was not so. The film’s fictionalized universe shows a day in the life of a firm sitting on a colossal heap of mortgage-backed securities, referred to as “toxic waste,” when a quantitative analyst is handed a file by the just-fired head of risk management. The executive had been updating his VaR3 (value-at-risk) models but didn’t finish, so his protégé assumes the task.

When explaining the situation to his new boss (Will), analyst (Peter) lays out the bleak future that awaits the company should the model be even partially accurate. The exchange goes something like the following:

WILL: What am I looking at?

PETER: The volatility boundaries are basically set using historic patterns then stretching them out another 10–15 percent — roughly. We are starting to test those historic patterns.

WILL: When?

PETER: Today, Tuesday, Monday, last Friday, and last Wednesday and Monday. Two Fridays ago…Once this thing gets going in the wrong direction…It’s huge.

WILL: How huge?

PETER: Well, the losses are greater than the current value of the company.

With stock and bond markets on largely vertical trajectories, it is especially challenging to recapture the fear and uncertainty that was gripping investors less than 10 years ago. It’s important to remember the 2008–2009 global financial crisis was, at its core, one of frozen liquidity — the perfect storm of deregulation, rapacious risk appetite, endemic conflicts of interest and delusory valuation models.

In the past, bonds were the “canary in the coal mine,” telegraphing potential headwinds in equity markets through the widening of credit spreads; however, that relationship may be sufficiently dislocated due to the zero — or, in some cases, negative — interest-rate environment, such that a relationship will only be obvious with the benefit of hindsight.

With great focus paid to excess returns relative to a benchmark, it is often overlooked that the path of least resistance for making money when the market goes up is to lose less when it goes down.


The graphic above, provided by Vivaldi Asset Management, illustrates the hedging characteristics of one type of alternative strategy. The hypothetical performance tracks that of stocks’ “lost decade” from 2000–2010. The 60/40 portfolio represents a 60-percent investment in the S&P 500 Total Return Index (with dividends, net of tax, reinvested) and a 40-percent investment in Barclays U.S. Aggregate Bond Index, hedged for currency moves. The balanced portfolio is equally weighted among the following: S&P 500, the Barclays Aggregate, the Vivaldi Merger Arbitrage Fund (VARBX), the NCREIF National Property Index and is net of fees with quarterly rebalancing.4

Both the 60/40 and balanced portfolio were better options than a pure equity allocation; however, it was the balanced portfolio that managed a small return versus the other two — requiring less ground for investors to make up in the wake of two punishing bear markets less than a decade apart.

The strategy used in this illustration — merger arbitrage/event-driven5 — is only one of many. The graphic below presents some of those more commonly used strategies. Because each investor is unique in terms of time horizon as well as risk and liquidity profiles a thorough review with your financial advisor can help you arrive at the most prudent and advantageous allocation, given your unique circumstances.

While aviation nomenclature is frequently used to describe market oscillation, stock market turbulence is notoriously resistant to forecasting, marking its sudden reappearance with violence. Whereas most passengers have time to put on their seat belts, the same cannot be said for investors. Were Noah to be a surprise guest on National Geographic’s Doomsday Preppers, the teaser would likely have him wisely suggesting that it is best “to build the ark before the flood.” In terms of your portfolio, the time to think of hedging is when everyone is going all in, not when they are cashing out.


Margin Call, 2011, Written and Directed by J.C. Chandor, Produced by Before the Door Pictures and Washing Square Films, Distribution by Liongate


1 Milnes, Paul. “The History of Hedge Funds” HedgeThink, February 2014

2 Under federal securities law, an accredited investor is one having a net worth of at least $1,000,000 (excluding primary residence) or with an income of at least $200,000/year for the last two years ($300,000 if married) — with the expectation the income level will persist

3 VaR (Value at Risk) is an estimation of the mark-to-market loss on a fixed portfolio over a fixed time horizon. It is used by both firms and regulators to gauge the amount of assets needed to cover possible losses

4 For the illustration created by Vivaldi Asset Management, the following assumptions were made

Traditional Asset Classes

  • Equities are represented by the S&P 500 Total Return Index with dividend reinvested (net of withholding tax)
  • Fixed income is proxied by the Barclays US Aggregate Bond Index, hedged for currency moves

Non-traditional Asset Classes

  • Real estate is represented by the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index
  • Alternatives are represented by the Vivaldi Merger Arbitrage Fund (VARBX)

5 A merger arbitrage strategy is a type of event-driven investing that attempts to exploit pricing inefficiencies from corporate events. The initial announcement of a merger or acquisition will typically cause the stock price of the target to reflect the offer price and discount it for the likelihood and timeframe for the deal to close.  This strategy is positively correlated to rising interest rates – which pose a challenge to bond investors:

“When interest rates rise, bond investors have the wind in their faces, but we have the wind at our backs,” says John Orrico, portfolio manager of Arbitrage Fund.


All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Past performance is no guarantee of future results.

Neither asset allocation nor diversification assures a profit or protects against a loss in declining markets. An investment cannot be made directly in an index.

Special Risks: “Alternative” mutual funds may be considered speculative and involve substantial risks. These products may use investment techniques that are different from the risks ordinarily associated with equity investments. It is possible that investors may lose some or all of their investment. Turnover for some of these funds may be very high. This could result in relatively high transaction costs which could hurt the fund’s performance and cause capital gains tax liabilities. Some of these funds make use of the short sales of securities, which involves the risk that losses may exceed the original amount invested. However, a mutual fund investor’s risk is limited to the amount invested in a fund. Some “alternative” funds may also use options and futures contracts, which have the risks of large losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of securities prices, interest rates, and currency exchange rates. Investments in “absolute return” funds are not intended to outperform stocks and bonds during strong market rallies. No investment strategy, including an “absolute return” strategy, can ensure a profit or protect against loss. Some “alternative” funds involve the risk that the macroeconomic trends, company-specific events or temporary divergences in longterm statistical relationships between assets identified by fund management will not come to fruition and their advantageous duration may not last as long as the manager’s forecasts. Some “alternative” funds may invest in derivatives which often involves leverage that may increase the volatility of the fund’s NAV, and may result in a loss. In addition, derivatives can be difficult to value and changes in the value of a derivative held by a fund may not correlate with the underlying instrument or the fund’s other investments.

The S&P 500 Total Return Index is a free-float market capitalization index of 500 large publicly held U.S.-based companies, capturing 75 percent coverage of U.S. equities. It is often used as a proxy for the American stock market.

The Barclays Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and nonconvertible investment grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity.

The NCREIF Property Index (NPI) is a quarterly, unleveraged composite total return for private commercial real estate properties held for investment purposes only. All properties in the NPI have been acquired, at least in part, on behalf of tax-exempt institutional investors and held in a fiduciary environment.

The Chicago Board Options Exchange Volatility Index, or VIX, as it is better known, is used by stock and options traders to gauge the market’s anxiety level. It is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days and is quoted as an annualized standard deviation.