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The article first appeared in the December issue of REP . magazine and online at WealthManagement.com Along with other Yuletide treats, some Yanks are now anticipating the gift of a Fed rate hike. Better-than-expected employment numbers, an uptick in the manufacturing sector and pickup in wages have given the U.S. central bank the backstory for normalizing the nation’s monetary policy. The odds of a rate step-up, implied by Federal Funds futures, shot up from 7 percent to 70 percent in November. Simultaneously, expectations pushed the Treasury long bond yield up nearly a quarter of a point, effectively discounting the Fed’s anticipated action. Now that the markets have priced in the first Fed rate hike, it’s debatable whether it will be “one-and-done,” or the first step along a steady path of snugging. Either way, the die is cast: Rates are bound to rise, and sooner rather than later. With the coming of the end of the zero-rate environment, investors and advisors must rethink their portfolio strategies, most especially their alternative investment allocations. The basic question facing them now is which exposures are most likely to continue providing risk diversification in a rising rate environment. To answer that question, let’s look back at the liquid alt universe over the past five years and gauge each category’s correlation to a fixed income market proxy, the iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ). AGG tracks an index of investment grade notes and bonds including Treasuries, agencies and corporates as well as mortgage- and asset-backed paper, all with a weighted average maturity just under 13 years. Currently, AGG offers a 2.4 percent distribution yield. Two Things An ideal diversifier should be negatively correlated to AGG. Thus, when rates rise (and AGG’s price, as a consequence, falls), the alternative investment should appreciate. There are five categories that are negatively correlated to AGG: arbitrage, hedged equity, commodities, long/short equity and market-neutral. Based on the foregoing criterion alone, the arbitrage category seems to have the best track record over the past five years. Keep in mind two things, though. First, the correlation coefficient doesn’t measure cumulative returns. It only depicts the statistical relationship between each investment’s month-to-month price movements. And second, the category performance represents the market-weighted average of several portfolios. The arbitrage category, for example, comprises five products, four mutual funds and one exchange traded fund (ETF). Market weighting gives us insight into investor behavior and allows us to more clearly see how investors are actually putting their capital to work. The stand-out arb portfolio is the relatively small Quaker Event Arbitrage Fund (MUTF: QEAAX ) with a correlation of -0.21 to AGG and an average annual return of 2.39 percent. QEAAX deals in mergers, takeovers, spin-offs and other reorganizations, hoping to capture securities mispricings. The obvious problem with QEAAX, if a problem is to be found, is its high correlation to equities. QEAAX, after all, buys and sells stocks. If the prospect of rising rates spooks the equity market, as indeed it seems to have done, the Quaker fund’s NAV will likely be pressured. Hedged equity funds are also highly correlated to the broad stock market. The “hedge” in the category’s title refers to the variety of strategies employed by constituent funds to attenuate, but not necessarily eliminate, beta. The Schooner Fund (MUTF: SCNAX ), for example, is a long-biased fund that utilizes a buy-write (covered call) strategy to boost income. That said, SCNAX, with a -0.19 correlation to AGG, benefits most from a mildly bullish equity market. SCNAX pays just 0.57 percent in dividends. Commodity funds-long-only indexed portfolios-are only modestly correlated to stocks, but are suffering from a four-year disinflationary malaise. All, save one, are negatively correlated with AGG. It’s the PIMCO Commodity Real Return Strategy Fund (MUTF: PCRIX ), which overlays an actively managed fixed income strategy atop the index portfolio, that earns a 0.04 correlation to AGG. It should come as no surprise that long/short equity funds are highly correlated to the broad stock market. Nearly half of the 16 funds in the category, in fact, correlate to the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) at better than 0.85. Of these, one with the most negative correlation to AGG (-0.31) is the Diamond Hill Long-Short Fund (MUTF: DIAMX ), a portfolio that commands a 22 percent share of the category. Market-neutral funds attempt to hedge out general market exposure, i.e., aim for a beta near zero, to allow full expression of the manager’s concentrated bets. The multi-manager Deutsche Diversified Market Neutral Fund (MUTF: DDMIX ) accomplishes this with the category’s most negative correlation to AGG (-0.16). Alternative Income There’s a category we haven’t yet examined: alternative income. Three funds, in particular, have five-year track records, two mutual funds and an ETF. Collectively, these funds exhibit a modestly negative correlation (-0.06) to AGG, though you can see there’s a fair degree of “zig” to AGG’s “zag” in Chart 2. Viewed separately, these funds offer distinct value propositions: The $7.6 billion ALPS Alerian MLP ETF (NYSEARCA: AMLP ) tracks the price and yield performance of the Alerian MLP Infrastructure Index, a modified capitalization-weighted and float-adjusted benchmark of two dozen U.S. energy master limited partnerships (MLPs). To allow a full allocation to MLPs, AMLP is structured as a C-corporation, which means it can’t pass through the full return of its underlying index. Payouts are distributed net of corporate tax, which translates into a daunting expense ratio of 5.4 percent. The good news is that most of these distributions come tax-deferred to investors, making its 8.4 percent distribution yield doubly attractive. Worse News There’s, of course, worse news: The energy sector’s tanked this year, taking AMLP’s share price with it. The fund lost 28 percent on the year through mid-November. The JPMorgan Strategic Income Opportunities Fund (MUTF: JSOAX ) is an unconstrained bond fund with an absolute return orientation. The $18.4 billion fund has the flexibility to allocate its assets across a broad range of fixed income securities and derivatives as well as strategies employing cash and short-term investments. JSOAX is not afraid to load up on high-yield securities. JSOAX tends toward a short duration and holds a heavy slug of cash, all of which reduce its interest rate risk. The fund offers a 2.6 percent distribution yield. At $698 million, the Highland Floating Rate Opportunities Fund (MUTF: HFRAX ) is the category’s smallest asset collector. Still, it’s the best performer. HFRAX invests in floating rate bank loans-obligations with interest rates pegged to a spread over Libor (the London Interbank Offered Rate). This puts the fund in the catbird seat in a credit-tightening cycle. Currently, the fund offers a 5 percent distribution yield. You can see in Table 2 the countertrend nature of the HFRAX fund in its -0.22 correlation to AGG and a Sharpe ratio 40 basis points above that of the iShares product. So what have we learned from our little exercise? Simply this: When it comes to hedging interest rate risk, fund performance doesn’t draw assets. At least not yet. The Highland HFRAX fund, despite its impressive metrics, remains relatively obscure. It accounts for barely one-half of 1 percent of the alternative funds’ assets examined here. Perhaps that makes this fund-and newer funds on similar trajectories-undiscovered gems in the upcoming rate environment.