The Event-Driven Asset Class in a Rising Rate Environment

By Paul Hoffmeister and Thomas F. Kirchner, CFA, of Quaker Funds

One of the most common concerns today among financial advisors seems to be the prospect of rising long-term interest rates in the United States and what to do with U.S. fixed income exposures. In search of a potential solution, we examined the history of the event-driven asset class. The results show highly compelling risk-adjusted returns
in rising interest rate environments that could benefit traditional portfolios.

We used weekly data of the 10-year Treasury yield since 1990 as a proxy of the interest rate environment. Of course, since that time, the 10-year Treasury yield exhibited a secular downward trend from 9.02% to 1.47%, and its pattern was cyclical as the yield periodically rose to short-term highs and fell to new short-term lows.

For the purposes of our examination of this time period, we defined a rising interest rate cycle as any point in which the 10-year Treasury yield realized a short-term trough1 and then a short-term peak2, assuming that the trough and peak met certain criteria:

Two criteria required to identify a trough:
• The lowest inflection point between two peaks
• Inflection point must represent a new low point that is below previous troughs

Two criteria required to identify a peak:
• The highest inflection point between two troughs
• Inflection point must be greater than 1.5x in value than the most recent trough

This information is illustrated in Figure 13, shown below.

Using the above-mentioned criteria, six rising interest rate environments were identified in the United States during the last 23 years. Shown in Figure 24 are the returns and risk (represented by standard deviation5) data for the HFRI Event-Driven (Total) Index (“Event-Driven”), Barclays U.S. Aggregate Bond Index (“Bonds”), and S&P
500 (“Stocks”) during the months that these environments occurred:

The historical data since 1990 suggests that Event-Driven generated strong risk -adjusted returns versus Stocks  and Bonds during the era’s six rising interest-rate environments.

Of those six periods, Event-Driven outperformed Bonds every time. Event-Driven outperformed Stocks during three of those six times. Importantly, when looking at the returns in the aggregate for the five periods excluding the December 1995 through June 1996 period, Event-Driven generated relatively substantial returns with 30% to 61% less risk based on standard deviation.

These observations about the performance of the event-driven asset class validate its use by numerous asset allocators as an attractive alternative to stocks and bonds. In our opinion, the recent increase in popularity of event-driven hedge funds among institutional investors is based, in part, on their concern about the outlook for bonds and their understanding of the performance of the event-driven asset class during rising interest rate environments.

So how can an individual think about adding Event-Driven into their portfolio? The table shown in Figure 37 portrays a traditional retail portfolio built upon a 60/40 allocation. Between January 1990 and September 2013, this hypothetical portfolio of 60% Stocks and 40% Bonds would have generated an annualized 8.53% return with a
standard deviation (representing volatility) of 9.10% (when rebalanced annually).

Based on the historical data, by adding a 20% allocation to Event-Driven and equally reducing the portion devoted to Stocks and Bonds, the hypothetical investor increased his or her annualized return to 9.23% and reduced standard deviation to 8.53%. We believe this holistic solution, where one can possibly improve returns and reduce risk, is one of the many reasons why institutional investors have been using the event-driven asset class for decades.


1 A trough must be the lowest inflection point between two peaks, and the inflection
point must represent a new low point that is below previous troughs.
2 A peak must be the highest inflection point between two troughs, and the inflection
point must be greater than 1.5x in value than the most recent trough.
3 10-Year Treasury Yield. Source: Federal Reserve Bank of St. Louis, Economic Research.
4 Summary Performance Statistics During Rising Interest Rate Periods. Source: Zephyr
StyleADVISOR®. All returns and standard deviation calculations greater than one year
are annualized in StyleADVISOR.
5 Standard Deviation is a statistical measure of portfolio risk or volatility, used to
measure variability of total return around an average, over a specified period of time.
6 The basis point is commonly used for calculating changes in interest rates, equity
indexes and the yield of a fixed-income security. The relationship between
percentage changes and basis points can be summarized as follows: 1% change =
100 basis points, and 0.01% = 1 basis point.
7 Risk/Return Table January 1990 – September 2013: Annualized Summary Statistics.
Source: Zephyr StyleADVISOR®

RISK WARNINGS: Mutual fund investing involves risk, including the possible loss of principal.
Consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. The Statutory, and where available, the Summary Prospectuses contain this and other important information and are available for download at or by calling 800.220.8888. Read carefully before investing.
Event-Driven investing typically entails but is not limited to transactions in merger arbitrage, capital structure arbitrage or in distressed securities which involve special risks and requires special investment expertise.
Merger Arbitrage Risk: When investing in merger arbitrage, the investor retains the risk that the proposed corporate reorganization is not completed. This risk is also referred to as “Event Risk,” the event that the merger is not completed. More specifically, the risk in merger arbitrage is primarily the event of non-consummation of the announced merger.
Capital Structure Arbitrage Risk: Capital structure arbitrage involves investing in two different types of securities issued by the same company if they are believed to be mispriced relative to each other. Typically, one of these securities is purchased, while the other is sold short. The perceived mispricing may not disappear or may even increase, in which case losses may be realized.
Distressed Securities Risk: Investment in distressed securities may be considered speculative and may present substantial risk of loss. Below investment- grade securities involve greater risks of default or downgrade and are more volatile than investment- grade securities. Additionally, below investment-grade securities involve greater risk of price declines than investment-grade securities due to actual or perceived changes in the issuer’s creditworthiness. Such securities are subject to the risk that the issuer may not be able to pay interest or
dividends and ultimately to repay principal upon maturity. Discontinuation of these payments could adversely affect the market value of the securities.
An investor must weigh these risks against the profit opportunity in each event driven investment.
Alternative Investments are speculative and involve substantial risks. Investors may lose some or all of their investment.
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