There has to be some way to evaluate how well your investment account is performing. One way to do this is to compare the performance of your account with a benchmark. For instance, you might compare the performance of the stock portion of your investment account with the performance of the S&P 500 or Dow Jones Industrial Average. The performance of the bond portion of your account could be compared to the Bloomberg Barclays U.S. Aggregate Bond Index. If your account is doing better than the index, then, arguably, your investments are performing well.
That is a legitimate position to take. If the S&P 500 is up, and your account is up more, then your investments are doing well relative to the market. If the index is down, and your account is down less, your investments are doing well relative to the market.
But if your investments are losing value, can it really be said that they are performing well? If your account is down 18%, is it any consolation that the index is down 20%?
It is easy to be a successful investor in a bull market like the one we have enjoyed since March of 2009 (which, by the way, is the longest bull market in U.S. history). Everything is up; the winds are at your back. It is much more difficult to make money in a bear market. To do so, you must (1) have access to the necessary investment tools; (2) know how to use them; and (3) know when it is time to use them. The key is to find investments whose performance is not driven by equity markets. Here are just a few of the investment tools that accredited investors can employ to make money in a bear market.
First Loss Strategies: Investors’ funds are allocated among a pool of managers, each of whom has posted its own funds in escrow as a backstop against losses, hence reducing risk of loss to investors. For example, if a money manager is allocated $1,000,000, that manager would put $100,000 of its own funds in escrow. Managers typically retain 85% of trading profits. Losses, on the other hand, are assessed entirely to the manager’s escrow account. The manager’s trading account is closed if its entire escrow account is lost. Managers also pay a platform fee on its trading capital, similar to margin interest, which boosts investors’ returns.
Drug Royalties: A pharmaceutical royalty is a contractual right to a portion of the revenues from the sale of a drug or life sciences product. Investors can access royalties through an equity investment or debt secured by a royalty’s cash flow. The benefits of drug royalties include yield, capital appreciation, a long asset life, low correlation to market indices, and relative insensitivity to economic events.
Merger Arbitrage: Managers of merger arbitrage funds attempt to lock in discounts on merger and acquisition deals by taking long and short positions in the companies involved. Managers typically take long positions in the company that is being acquired and short positions on the acquiring company. When a corporation announces its intent to acquire another corporation, the acquiring company’s stock price typically declines (producing a gain on the short position), while the target company’s stock price generally rises (producing a gain on the long position). Conservative merger arbitrage funds can have low volatility and little or no correlation to equity or fixed income markets.
Volatility Managers: Volatility managers identify and exploit inefficiencies arising from the price level and term structure of liquid, listed equity market volatility-related instruments. They establish spread positions to capture these inefficiencies to harvest risk premium in the roll curve of various instruments used to hedge market volatility.
Diversification is the key to building better risk-adjusted portfolios. At the portfolio level, diversification can deliver risk-canceling benefits without diminishing expected long-term returns. Unfortunately, the level diversification achieved through stocks and bonds alone simply is not always sufficient to preserve wealth in all market conditions. Risk-adjusted returns can be improved by adding non-correlated assets to a traditional portfolio. Alternative strategies offer powerful diversification benefits – and greater risk-adjusted returns – when combined with stocks and bonds.
Importantly, investor psychology studies have shown after long periods of above-average market returns investors become complacent and overconfident in their abilities. They often do not appreciate the degree of risk they have assumed in order to generate the returns they have enjoyed; and investors often take the most risk towards the end of bull markets, heightening their pain when the market declines and volatility increases. By minimizing portfolio volatility through better diversification, investors will be better positioned to successfully navigate a bear market.