With the presidential election less than a month away, and the two candidates running head-to-head in the polls, there is certainly a lot of uncertainty in the markets. That is best visualized by the S&P 500’s option market and its volatility surface:
The key takeaway? As illustrated in the red section of the graph, investors are paying a premium to secure protection for the next 3-6 weeks. While options can be an effective way to hedge against a market downturn, another viable approach is through alternative liquid strategies.
Put options, which many investors are currently purchasing, yield profit only if a specific outcome occurs—the S&P 500 declines. Should the market rise or even remain stable after the election, the value of those options would diminish. In contrast, alternative strategies offer their protection potential through diversification. Their return drivers are uncorrelated or have low correlation with equity markets, allowing them to potentially reduce portfolio volatility and enhance resilience across various market conditions.
Drawing on monthly returns dating back to 1989, the table below presents the average monthly performance of various funds, highlighting that Q4 tends to be a strong quarter for equities, fixed income, and liquid alternatives. Event-driven strategies, which capitalize on corporate actions such as regulatory changes, merger arbitrage, and bankruptcies, typically perform exceptionally well during this period. In fact, December has historically been the best month for these strategies.
This trend is not surprising—companies, and especially their leadership, aim to start the new year with a clean slate by resolving any outstanding business. If a merger, bankruptcy proceeding, or similar event is still pending as the fourth quarter progresses, management often strives to conclude it by year-end, avoiding the burden of unfinished business at the start of the new year. Leaving such issues unresolved could also complicate earnings calls, comparisons, and other reporting matters. In essence, the mantra of ‘New Year, New Me’ also extends to companies.
Morningstar. Monthly Data from 1989 – September 2024. ‘US Fund’ constitutes an equal weight average contribution of all the funds within Morningstar’s defined category that has data at that time. So US Fund Event Driven Monthly Returns constitutes the average monthly performance of all US Event Driven funds.
But how does this relate to elections? Alternative strategies can help diversify a portfolio’s return drivers and offer protection during periods of uncertainty. A multi-strategy fund, which provides exposure to various alternative strategies wrapped up into a single investment, can act as a versatile “Swiss Army knife” in a portfolio, helping to reduce volatility and smooth out returns. While allocating to a specific alternative strategy may increase both risk and potential returns, each strategy carries its own distinct set of risks. For event-driven strategies, the primary risks are that a deal may collapse or, even if completed, the process might take longer than expected, rendering the trade unprofitable.
Traditionally, fixed income has served as a reliable hedge against equities during downturns. However, in a low-yield environment characterized by heightened fixed income volatility, bonds have become less effective diversifiers—consider 2022 as a case in point. Even though yields are now significantly higher than at any time in the past decade, volatility remains elevated; the 10-year Treasury yield, for example, rose nearly 50 basis points over the past month.
Against this backdrop, alternatives may offer valuable diversification and protection. Examining return data from every U.S. presidential election over the past thirty years, multi-strategy and event-driven funds have not posted a single negative one-year return. Here, “one-year return” is defined as the performance from October of the election year through September of the following year—for instance, October 1992 to September 1993.
Fixed income has struggled in recent election cycles, with bonds averaging a return of -0.83% over the last three elections. Looking beyond just returns during the one-year period surrounding an election, alternative strategies have delivered strong risk-adjusted returns:
If one focuses on just the data from this century, i.e. from 2000 to present, the data may be even more compelling:
While the risk metrics for event-driven strategies remain relatively stable, returns from other asset classes tend to drop by 30-40%, all while maintaining similar levels of volatility. Although future returns and election outcomes are inherently unpredictable, alternatives—especially event-driven strategies—have historically served as effective hedges against market uncertainty during election years and have the potential to serve as effective hedges in the future. This is because their return drivers are largely independent of election results. Additionally, as we enter a historically strong seasonal period for these strategies, there is even more incentive to consider adding them to a portfolio.
By: Nicholas Codola, CFA, CAIA, Sr. Portfolio Manager
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Disclosures
Orion Portfolio Solutions, LLC d/b/a Brinker Capital Investments is a registered investment advisor.
This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. This information is prepared for general information only. Individual client accounts may vary. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed and should understand that statements regarding future prospects may not be realized. Investors should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Investing in any security involves certain non-diversifiable risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any specific, or diversifiable, risks associated with particular investment styles or strategies.
The S&P 500 Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large-cap stocks. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index.
2661-BCI-10/16/2024
