The Risk in Liquid Alternative Credit Funds

Before we look at the response of liquid alternative credit funds to interest rate movements, we give two brief definitions of alternative-investment funds in general:

Risk Diversifiers:

• They have correlations that tend to be (but are not necessarily) low vis-à-vis the existing portfolio or compared to long-only asset classes such as stocks, bonds, and commodities.
• They contain an active component that is often (but not exclusively) a hedge fund or a hedge fund-like strategy.
• They can be used as a substitute for some fraction of the bond holdings in an investor’s portfolio or to reduce the risk of individual asset classes.

Return Enhancers:

• They contain an active component that is often (but not exclusively) a hedge fund or a hedge fund-like strategy.
• They can have relatively higher returns than alternatives that diversify.
• They can have significant correlation(s) to major bond and/or stock indices.
• They can be used as a substitute for some fraction of the equity holdings in an investor’s portfolio.

Alternative credit funds can have one or both of these properties. If we look at the performance of unconstrained bond funds as an example over the past few years, the case can easily be made that they are return enhancers. Accepting that definition or classification for the moment, what should separate the performance of an unconstrained bond fund (or any alternative credit fund) from a long-only bond fund is its performance in a down market; that is, a well-constructed return-enhancing credit fund should perform no worse than and at least nominally better than a long-only bond fund in a declining bond market, i.e. one where interest rates are rising. We will now test this hypothesis across all types of alternative credit funds in the current article.

We choose as our test period the last 18 months, given the volatility and on-again, off-again movements in interest rates. Figure 1 shows how the U.S. Treasury yield curve changed from October 1, 2012 (in purple) to April 7, 2014 (in orange). Note the bars in red below the curve chart, in particular the change in the five-, seven-, and ten-year yields. They have gone up 1% or more since October 2012.

Figure 1. U.S. Treasury Yield Curves–10/1/2012 Through 4/7/2014

Source: Thomson Reuters

Figure 2 is a plot of the CBOE/CBOT Ten-Year Treasury Volatility index. Note the change in level over the period as well as the increased “chop” after the October 2012 April 2013 period.

Figure 2. Ten-Year Treasury Volatility Index, 10/1/2012 Through 4/7/2014

Source: Thomson Reuters

We will measure the risk-management aspects of alternative credit funds via downside deviation (a measure of downside risk) and maximum drawdown (the maximum amount of a fund’s loss through the drawdown period and back to the point the fund’s high is reached again). For purposes of comparison we choose a group of exchange-traded funds (ETFs) as benchmarks and/or proxies for typical bond investor holdings. If alternative credit funds are doing their job, their downside deviation and maximum drawdown values should be better than some or all the ETFs.

The bond ETFs we use are: SPDR Barclays Aggregate Bond, SPDR Barclays Intermediate Term Corporate Bond, iShares iBoxx High Yield Corporate Bond, SPDR Barclays Long Term Treasury Bond, and SPDR Barclays Long Term Corporate Bond.

Of the 39 distinct alternative credit funds in the U.S. that have at least 18 months of return history, 11 have better downside deviation and maximum drawdown values than any of the ETF benchmarks/proxies (see Table 1).

Table 1. Results of Downside Deviation and Maximum Drawdown Tests

Source: Lipper, a Thomson Reuters company

On the risk management side the 11 funds in Table 1 validate our hypothesis that there are alternative credit funds that show a better performance in down or volatile bond markets versus a long-only bond fund, in this case a well-diversified long-only bond fund.

On the flip side of risk management a well-performing alternative credit fund will have a risk-adjusted return that is at least equal to, if not better than, its associated ETF. In Table 2 we show that the 11 funds in Table 1 have better Sharpe and Sortino ratios than SPDR Barclays Aggregate Bond ETF, which they outperform on the risk management side.

Table 2. Results of Sharpe and Sortino Ratio Tests

Source: Lipper, a Thomson Reuters company

Since corporate bond funds are popular with investors, we look at SPDR Barclays Intermediate Term Corporate Bond ETF’s downside deviation and maximum drawdown values. The Corporate Bond ETF values are only a little worse than SPDR Barclay Aggregate Bond’s, so the same 11 funds plus one more – Alliance Bernstein Unconstrained Bond Fund;A – had better risk management metrics than the SPDR Corporate ETF. On the risk-adjusted side the SPDR Corporate ETF had a higher Sharpe ratio than all the alternative credit funds but a substantially lower Sortino ratio. This split is to be expected, given the purposes alternative credit funds can and are put to versus bond ETFs.

Traditionally, the Sortino ratio is a complement to an investment thesis or investment language that stresses keeping losses to a minimum. The same cannot be said for the Sharpe ratio because of the way it does not “punish” what is called “harmful volatility,” i.e., any returns below a minimum stated level  of return (in our case three-month U.S. Treasuries).  The Corporate Bond ETF with its lower Sortino ratio and higher downside deviation and maximum drawdown all carry the same message: this ETF can provide good returns but does not stress keeping losses to a minimum as an alternative credit fund may.

We show in this article that there are indeed alternative credit funds in the U.S. that produce good returns and, more to the point, better downside protection in a rising rate or volatile bond  market than “standard” ETFs. This argues for the allocation of some long-only bond money to alternative-credit instruments, given their ability to better protect an investor in a rising-rate or volatile-interest-rate environment.