Global Negative Interest Rates, What Should Investors Do?

Global Negative Interest Rates, What Should Investors Do?
Global Negative Interest Rates, What Should Investors Do?

By Donald A. Steinbrugge, CFA – Founder and CEO, Agecroft Partners

Investors must always consider and be prepared for major corrections in the capital markets. Experience shows the question is not if a major correction will happen, but when. As the economic landscape becomes increasingly tumultuous, it is imperative that investors construct portfolios that reduce tail risk and address the possibility of a major market correction.

Although the probability of a tail risk scenario has increased, no one knows how this is all going to end since we have not been in this environment before. Instead of trying to time the market, investors should construct a diversified portfolio that can withstand market turbulence. This can help avoid desperate reactions which typically include selling at market bottoms. Unfortunately, most investors significantly underestimate the tail risk of their portfolios.

When building out a diversified portfolio, many investors seek to maximize risk-adjusted returns for a multi-asset class portfolio. Calculations to determine optimal asset allocations require assumptions for return, volatility and correlations (relative movement) for each asset class.  These assumptions are based on a combination of long-term historical returns for an asset class, current valuation levels, and economic forecasts. Together, these variables can be applied to optimization models to help determine the asset allocation with the highest expected return for a given level of volatility.

Unfortunately, these models have proven to break down during severe market sell-offs. This was a painful lesson learned in 2008 when almost all asset classes declined simultaneously. The reason these models break down is because two of the inputs (correlation and volatility) are dynamic. When markets sell off, correlations among long only investment managers and across various asset classes tend to rise significantly. When combined with a spike in volatility, this creates much more tail risk than originally perceived. It is important to stress test portfolios using expected correlations and volatilities that would be experienced in a major market sell-off.

For those investors that currently have an allocation to hedge funds, it is important to remember that hedge funds are not an asset class but a fund structure comprising of numerous investment strategies. Many hedge fund strategies have very low correlations to capital markets benchmarks and some are, or have the potential to become, negatively correlated during a market sell-off. This was seen in 2008 when a few hedge fund strategies posted positive returns.

Below is a list and brief description of some of the most diversifying strategies that should be considered to reduce tail risk across a diversified portfolio:


This includes a range of strategies with very different return expectations and tail risks. The main common feature of these funds is their allocation to a portfolio of insurance policies where the primary drivers of return are insurance premiums earned and claims paid. Property risk (eg earthquake, fire, hurricane, and tornado) has proven to have very low correlation to the performance of the capital markets. This strategy has seen a significant increase in demand due to recent industry price increases.

Relative value fixed income

Strategies that provide liquidity to complex/less liquid fixed income securities have replaced bank proprietary trading desks. Skilled managers generate most of their return through alpha and actively hedge interest rate and credit spread risk.

Commodity Trading Advisors (CTAs)

This category includes several different strategies, but is dominated by systematic trend following managers. These managers look to identify and capture price trends across multiple asset classes including currencies, commodities, equities and fixed income. A pure trend follower is indifferent to fundamental analysis or market valuations. As such, their correlation to the capital markets is, on average, very low. In fact, many have dynamic correlations that are positive in up markets and negative in down markets. There are also many non-trend following CTAs that provide positive skew performance distribution that can provide valuable tail risk protection.

Specialty Finances/Private Lending

Most of these funds are taking advantage of the difficult environment for small and mid-sized companies in securing financing from traditional lenders. There are wide differences in credit quality and yields of funds within the private lending space, but yields are typically much higher than traditional marketable fixed income securities. Many funds hold relatively short term loans at book value and only adjust market value if there is an impairment to credit. As long as the liquidity provisions of the fund match the underlying investments, and absent a significant impairment to the credit quality of the loan portfolio, these funds can provide very stable uncorrelated performance.