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A Powerful Tool to Manage Market Volatility

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Merger arbitrage strategies

In times of market stress, investors often consider rash decisions of moving between risk-on equity exposures to risk-off vehicles, often when it is already too late. October has been a difficult time in the market, with the S&P 500 experiencing a six-day losing streak, its longest in two years, trading near its July 2018 level. Coming off one of the least volatile years in history, this type of market movement can be disturbing, but should be viewed in the longer-term context.

Breaking down some of the events that led up to the recent pullback, Federal Reserve messaging removed the word “accommodative” from its most recent post-meeting statement, and several Fed officials have suggested an intent to continue gradually raising rates. Higher rates generally increase the cost of capital for companies and lead to a higher discount rate for future earnings, making them less valuable now. The continuation of tariff talks may explain why Technology was hit harder than other sectors, over fears that their costs from overseas manufacturers could increase. Increases in Energy inventories leading the price of oil lower could have explained some of the energy sector losses.

When market sell-offs occur, investors immediately focus on the volatility of their portfolios as a targeted area for improvement and with the proliferation of Smart Beta strategies, investors have several solutions to address their concerns. However, while managing volatility is an important objective, investors must also consider correlation within their portfolio construction. Herein lies the benefits of Liquid Alternatives: daily access to strategies that are less correlated to traditional asset classes, potentially providing a differentiated source of return.1

One direct approach to tackling the high volatility of the S&P 500 major market index is the low volatility factor used by the S&P Low Volatility Index. In this index, the 100 names of the S&P 500 that exhibit the lowest trailing 12-month standard deviation (measure of volatility) are used instead of the full 500 names. If we look over the long-term2, the annualized volatility of the S&P 500 and S&P Low Volatility Index are 14.7% and 11.37%, respectively. The problem with using standard deviation in isolation is that there are plenty of stocks that have risen in a smooth fashion, exhibiting low volatility on the way up but ultimately having a relatively large potential to correct. The FANG stocks (Facebook, Amazon, Netflix, and Google), are a great example, being partly found in the S&P Low Volatility Index as it stands today. If we consider a Liquid Alternative strategy such as the IQ Merger Arbitrage Index, its volatility is at 4.57% (see chart below).

Annualized historical volatility

Source: Bloomberg, IndexIQ. Daily Annualized Volatility: 11/16/10 to 10/11/18. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Looking at long-run volatility versus the one-year rolling volatility, we can see how Low Volatility by itself does not address the full risk picture. Volatility does exhibit a mean-reverting tendency and this chart would indicate that rising volatility is in store for the S&P 500. Comparatively, the IQ Merger Arbitrage Index exhibits lower volatility on an absolute basis while also trending near its longer-term volatility level.

Related: Looking Deeper Into Currency Hedging

Increasing volatility, however, should not cause investors to completely run for the hills but rather give them pause to prepare their portfolios to weather the risk. Liquid Alternative strategies may have some of the same asset class exposures investors hold in their portfolios, but their construction leads to lower correlation strategies to equities and fixed income. Looking at the five-year correlation as of 9/30/2018, incorporating additional asset classes into your portfolio that exhibit low correlation to each other are necessary to offer additional diversification benefits to help control risk. For example, the IQ Merger Arbitrage Index exhibits 0.32 correlation to the S&P Index and -0.12 correlation to the Bloomberg Aggregate Bond Index.3

IQ Merger Arb Index MSCI EAFE Index Bloomberg Aggregate Bond Index S&P 500 Index FTSE NAREIT Index Bloomberg Commodity Spot Index
IQ Merger Arb Index 1.00
MSCI EAFE Index 0.26 1.00
Bloomberg Aggregate Bond Index -0.12 -0.10 1.00
S&P 500 Index 0.32 0.46 -0.28 1.00
FTSE NAREIT Index 0.24 0.59 0.14 0.57 1.00
Bloomberg Commodity Spot Index 0.15 0.32 -0.11 0.26 0.20 1.00

Source: Morningstar; Time period: 5 years monthly ending 9/30/2018. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Incorporating a liquid alternative strategy, such as the IQ Merger Arbitrage Index, has shown an ability to avoid the tail-risk (i.e. large negative losses) associated with increased market volatility. On October 10 and 11, when the S&P 500 was down -3.29% and -2.06%, the IQ Merger Arbitrage Index returned .10% and .06%.4

Market stress

Source: Morningstar, as of 10/11/18. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Value-at-Risk (VaR) is an often-used measure for risk which provides a probability level of minimum loss over a set period (day, week, month, etc.). For example, the 5% one-day VaR of the S&P 500 going into October 10 was -1.24%. Translation: there was a 5% probability that the S&P 500 could decline by more than -1.24% over the current day which it did at -3.29%. The following day, the 1-day VaR for the S&P increased to -1.30% which it exceeded again at -2.06%. While seeking lower volatility strategies may seem attractive, correlation can’t be ignored. As seen in the chart above, over the same two-day period, the S&P 500 Low Volatility Index 5% 1-day VaR was -1.02% and -1.04% respectively which it exceeded both days.

Comparatively, the IQ Merger Arbitrage Index one-day VaR limits remained at its -0.42% level over the market sell-off, which it did not exceed. More importantly, looking historically, the IQ Merger Arbitrage Index has breached its VaR limit less than 5% of the time looking over a contemporaneous period with the S&P 500. This lower than 5% exceedance occurrence illustrates the strategy’s ability to control tail-risk by delivering on the expectation of avoiding extreme losses.

Liquid alternative strategies with low correlation to broad asset classes may serve as a ballast to a portfolio over the long haul, exhibiting attractive risk-control characteristics to offer investors powerful tools to help their portfolios weather short set-backs to help achieve their long-term goals.

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