Four Takeaways On Alternative Opportunities Today by Marc Gamsin, Greg Outcalt, AllinaceBernstein

Dispersion among asset classes and individual stocks and bonds will likely increase, and that’s only one trend reshaping the landscape and redefining alternative investing opportunities. Here are four things investors should consider.

1) Higher dispersion is creating fertile ground for long/short strategies. The environment, particularly in the US, is favorable for long/short strategies. To start with, corporate and economic fundamentals are strong. We’re also seeing more volatility and dispersion—bigger distinctions between security valuations mean more active-management potential. And even though the US equity market seems fully valued overall, we still think there are misvaluations that make long/short approaches attractive.

We particularly favor strategies that can leverage increased dispersion if there’s an uptick in volatility. These strategies should use bottom-up, fundamental analysis to exploit long/short idiosyncratic—or security-specific—opportunities. We also think strategies that can take advantage of the impact of divergence in central bank policies could benefit.

Interest rates are low, markets for equity and credit financing are open, and there’s been a multiyear bull market. This combination has enabled low-quality companies to survive and go public, engage in financial engineering including undesirable buybacks, and increase their debt loads. These activities are increasing the available opportunities to take short positions.

2) The environment is strong for corporate deal making. Macroeconomic fundamentals, including low oil prices, low funding costs and strong corporate balance sheets, are fueling strong deal activity. This is creating an attractive environment for event-driven investing.

Corporate activity is near record highs in a number of areas, including new IPOs, spinoffs and mergers. Many of these activities result in changes to corporate structure, balance sheet composition, incentives and management quality. These events, in turn, create potential both on the long and short sides.

And because organic revenue growth is otherwise challenged in the low-growth economic environment, corporate deals continue to offer solutions that could be compelling for companies. We think the ability to invest across equity and credit markets is a key to capitalizing.

3) Relative value approaches face headwinds. The environment remains challenging for relative-value credit strategies, and volatility could be high. In terms of fundamentals, debt levels at US high-yield firms are at record highs, and the ratio of downgrades to upgrades is at a post-crisis high—both are concerns. These and other factors have limited the potential upside, particularly relative to the potential downside in price.

What about liquidity and market structure? Liquidity in many areas is low, even as money flowed into credit-focused investments. We think this backdrop sets up the possibility of investors being forced to sell into a less liquid market if an unexpected event occurs. Offsetting some of this risk is what seems to be a sizable amount of cash on the sidelines, ready to prop up higher-quality issues if there’s a broad-based dislocation.

Of course, the environment can change quickly if an economic downturn or market decline expands distressed credit opportunities. This would be especially true after a long bull market, in which weaker firms have been able to easily raise new debt and extend debt maturities. Strategies nimble enough to move into these areas of opportunity as they emerge could find a very rich opportunity set.

4) Some promise in emerging macro trends…with a caveat. Macro-level trends are becoming more prominent, creating more appealing opportunities than in recent years.

There are mounting geopolitical risks, including tensions in Ukraine and Russia, the threat of ISIS and economic question marks in the euro area. Heavy government debt is combining with slower global growth, market volatility is rising, and central bank policies are diverging. In emerging markets, lower commodity prices are causing dislocations. And when the US Federal Reserve raises interest rates, it should boost the dollar and put downward pressure on longer-term bonds.

This environment could provide the foundation for several long-term trends, creating potential for macro strategies. However, the long-term potential for strategies that haven’t yet experienced a low-but-rising interest-rate environment remains unknown. And the concentrated bets and high levels of leverage that these strategies often use continue to give us pause.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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