Impact of Rising Interest Rates? Alternatives may be part of the Answer

Prepared by Ryan S. Kitson

Executive Summary

Interest rates are one of the most misunderstood and influential economic indicators in the U.S. and around the world today, especially in regards to investments and investing. Positive and negative changes in interest rates and even uncertainty whether interest rates are going to change can have an impact on the value of a portfolio and which investment strategies should be targeted or avoided. Further, just the process of rationally evaluating the proper pricing and valuation of assets in this environment when risk free rates may be materially mispriced. This purpose of this paper is to discuss why interest rates are important for investors to understand, an overview of interest rates and Federal Reserve Bank operations, Quantitative Easing and why it was necessary, obstacles to overcome before interest rates can rise, and what alternative strategies perform best in periods of rising interest rates. In an environment where changes in interest rates exist, investment in alternative assets may be a light amidst a darkness of uncertainty.

Why Interest Rates should matter to investors?

Interest rates are a significant influence on how an investor decides to allocate their assets. Discussions and potential actions of interest rate movements either up or down by the Fed can invoke rational or irrational decisions by investors. When interest rates are low or decreasing, investors may look for returns based on equities but are also tempted by the positive growth in fixed income investments values. Periods of decreasing interest rates are also typical of periods of time when credit conditions and economic conditions have worsened or are worsening. When interest rates are high or increasing, investors seek returns from fixed income investments but are also fearful of decreasing values of those very same fixed income strategies. The relationship between interest rates and inflation can also significantly impact investors, especially investors that rely on fixed income securities. Generally, low interest rates coincide with high inflation. Inflation reduces the amount on interest paid to investors holding fixed income securities. There is major uncertainty going forward in the U.S. stock market. Interest rates are currently at an all-time low, and the returns on investment in the market are soaring. At the end of 2014, the Fed began discussing the eventual and gradual increase of interest rates once the economy was healthy enough to sustain a change. The Fed continues to monitor the U.S. GDP, unemployment rate, bank reserves, inflation, strength of the Dollar relative to other foreign currencies, and the global economy for indicators of a stable environment for an increase in interest rates. All of these factors contribute to the cloud of uncertainty surrounding interest rates, the Fed’s plan and how the stock market and economy will react. The uncertainty may eventually push investors to seek shelter. Diversifying a portfolio with alternative assets in an environment with rising interest rates could potentially be one of those shelters.

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Brief Overview of Interest Rates and Central Bank operations

Interest rates are defined as the amount, expressed as a percentage charged for the use of assets by a lender to a borrower. There are three types of interest rates: The Federal Funds Rate (“FFR”), Prime Rate and LIBOR. U.S. regulations require lending institutions to hold a percentage of their deposits each night with the Federal Reserve Bank (“the Fed”). The FFR is defined as the interest rate on excess reserves that banks lend to one another. In return for requiring lending institutions to keep a percentage of their deposits with the Fed, they are paid interest that typically falls within the Fed Fund target range established by the Federal Open Market Committee (“FOMC”). The Fed can influence the level of the FFR by commencing FOMC operations. FOMC is the process where the Fed purchases and sells government securities to impact the amount of excess reserves a bank holds. A higher amount of excess bank reserves equates to a lower FFR, and vice versa.

The Prime Rate is most common with different types of lending (i.e. bank loans and credit cards). The Prime Rate (“interest rate”) is generally the FFR plus three percent and is extended to the most creditworthy of borrowers. LIBOR is the amount banks charge each other for borrowing Eurodollars on the London interbank market. LIBOR is an international version of the FFR.

The Fed uses both FOMC and changing the reserve requirement percentages to maintain stability in the financial market. In 2008, the U.S. economy experienced the Great Recession which made FOMC and adjusting reserve requirements ineffective in balancing the financial market. The Fed was forced to seek an alternative, Quantitative Easing.

What is Quantitative Easing?

Prior to the recession in 2008, the Fed could manage inflation simply by adjusting the interest rate overnight at which banks would borrow. If banks were getting nervous regarding the future and decided to scale back investment reserves accordingly, the Fed would reduce the overnight interest rate. As a result, the lower interest rate would reduce bank’s funding costs thus encouraging them to create more loans and keeping the economy from falling into a recession. If credit, spending, and inflation were increasing, the Fed could increase the overnight interest rate. By contrast, the rise in interest rates increases loan funding costs and discourages banks from lending. When the 2008 economic crisis struck the U.S., the Fed responded by lowering the overnight interest rates to virtually zero. This action did little to spark an economic recovery. In response, the Fed began to experiment with another tool to inject money into the struggling economy. Quantitative Easing (“QE”) was the result. QE is the practice of creating money in the economy by buying government securities, bonds and mortgage backed securities (“MBS”) from banks with electronic cash that did not previously exist. The new money increases bank reserves thus enticing banks to lend more money and purchase securities and bonds to replace the ones sold to the Fed. The result of QE is a lowering of interest rates and an increase in stock prices, which boosts investments and economy. The Fed has engaged in QE three times in history to stimulate U.S. economic recovery post-recession of 2008. A serious commitment by the Fed through QE

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to fight deflation and high unemployment has led to an increase in economic activity and overall confidence in the U.S. economy.

Are Interest Rates going to rise?

Historically, an increase in the money supply leads to an increase in interest rates and inflation. Milton Friedman, an economist defines the money supply as M0 (“monetary base”), M2, and M3. Monetary base is the sum of currency in circulation, demand deposits and reserve balances held by financial institutions in their accounts at the Fed. M2 includes monetary base plus time accounts less than $100,000 that can be easily converted in demand deposits. M3 includes monetary base and M2 plus time deposits of more than $100,000 and long-term repurchase agreements. History is riddled with several examples of central banks and governments “pumping” money into a struggling economy and causing inflation or hyper-inflation. Two of the most notable cases of hyper-inflation were in the $100 trillion Mark in the Weimar Republic of Germany in 1923 and the $100 quintillion Pengo in Hungary in 1946. Both instances had massive deflation where a central bank printed money in a desperate attempt to stabilize each economy. In 2008, the U.S. experienced a deflationary phenomenon as the housing market bubble burst causing the values of securities tied to real estate to plummet which significantly damaged financial institutions. As a result of this crisis, the Fed engaged in several rounds of QE to save financial institutions and economy. From a historical perspective, a central bank creating and injecting money into an economy should’ve created inflation or potentially hyper-inflation, but the Fed’s action didn’t. Like most countries, the U.S. operates under a Fractional Reserve Banking system where only a “fraction” of bank deposits are backed by cash on hand and are available for withdrawal. Typically, a bank uses its deposits to make loans and collect interest, which it uses to make more loans and be profitable (“money multiplier effect”). If the multiplier is set at 10x, for every $100 deposited, $1000 in new credit money is created. Since M2 is a product of M0 plus fractional reserves and credit it should’ve created inflation when the Fed bought U.S. Treasury bonds (“UST”), MBSs and increased bank reserves. QE did not lead to rampant inflation like many speculated. Unlike other countries that experienced a severe inflation, the U.S. economy was already in a state of deflation when the Fed began using QE. Additionally, the money that was injected into monetary base was not multiplied through the credit system and flushed out to the economy; it was hoarded by banks. Banks used the additional reserves to fix their balance sheets and regain profitability that was lost during the housing bubble burst which created bad loans and toxic assets. The net result was increasing the monetary base, re-establishing stability within the financial industry without spiking M2 that would create inflation. Since completion of the rounds of QE, the U.S. economy has remained productive and has grown slowly. The Fed is currently monitoring the output, labor market, and wages to assess when the economy is healthy enough to sustain an increase in interest rates.

According to Janet Yellen (Economist and Chair of the Board of Governors of the Federal Reserve System) and the Fed, a slow and methodical increase of interest rates was expected to start during Q1 of 2015. As of October 31, 2015, there has been no increase in interest rates. There is a possibility of an interest rate increase in early 2016 or once the new Gross Domestic Product (“GDP”) numbers are published. The Fed continues to examine data to determine if the economy is strong enough to handle an increase in interest rates. The perception is that the Fed is extremely slow to react and is waiting for

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outcome data to confirm the “right” time to raise interest rates. That perception is incorrect, as the Fed is actually attempting to measure the amount of slack in actual output compared to full capacity output in the economy. Measuring the slack in the output of the economy is difficult. One of the key metrics is real wage rate growth. When the economy is at full capacity, companies will be unable to attract employees at the current wage rate thus causing wages to rise. As real wages rise, the output slack in the economy will evaporate leading to inflation. As inflation increases following the full capacity output, the Fed can then begin to raise interest rates to keep inflation from exceeding their target. There are a significant amount of obstacles and factors the Fed must consider before it attempts to raise interest rates, such as:

An increase in interest rates may send shockwaves through global economies if the pace of the increase and/or the inflation expectations exceed forecast. Markets tend to react poorly if surprised to the downside and react buoyantly if surprised to the upside. Interest rates are highly correlated to the U.S. Dollar (“Dollar”). The Dollar is measured against a basket of the six largest world currencies’ (euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona, and Swiss Franc) exchange rates. As interest rates move, the Dollar’s value relative to other currencies moves similarly. A strong Dollar impacts global economies, especially ones that are emerging markets and rely heavily on exports. A transfer of demand from U.S. products to foreign products occurs when interest rates and the value of the Dollar increase causing the U.S. to be a net importer of goods and services. While the transfer of demand from U.S. products to foreign products balances the global economy, it also negatively impact U.S. multi-national corporations that conduct operations overseas and derive 15% or more of their revenues from abroad. The strong Dollar causes U.S. goods to be more expensive to foreign consumers, which puts downward pressure on demand and U.S. multi-national corporation revenues. The GDP is comprised of Personal Consumption (70%), Government Spending (14%), Net Exports (14%), and Business Investment (2%). A strong Dollar is also beneficial to the U.S. economy. The purchasing power of the Dollar carries more weight abroad, making travel and foreign products cheaper to U.S. consumers. A strong Dollar also creates less expensive imports for U.S. consumers and companies benefit from lower input costs thus increasing their profit. Additionally, foreign companies that conduct a large amount of business in the U.S. also benefit from a strong Dollar by converting sales obtained in Dollars into their local currency. Investors in foreign companies with U.S. sales also benefit from increased revenues’ impact on return on investments. While a strong Dollar does have a negative impact on Net Exports of the GDP, it does have a net positive effect for the U.S. economy as a whole and benefits for other global economies.

In addition to impacting the value of the Dollar, a rise in interest rates also affects the U.S. job market. There is a two-fold effect on the job market. For multi-national corporations that have revenue streams from overseas operations, an increase in interest rates puts downward pressure on revenues; thus, limiting a company’s ability to expand its operations and hire more employees. Furthermore, a rise in interest rates increases a corporation’s cost of borrowing. A surge in interest rates hinders a company’s ability to acquire funding to cultivate organic growth.

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Multi-national and domestic companies that export goods and services can potentially mitigate the risk associated with rising interest rates by investing in currency options and currency based futures contracts. Both investments provide an opportunity to lock-in an exchange rate to recover losses incurred when converting foreign currency to the Dollar. As of 2011, the aggregate national balance of cash and equivalents for US companies was approximately $5 trillion. With uncertainty surrounding interest rates, companies can potentially use the excess cash on hand for expanding operations to nullify the impact on the cost of borrowing by increasing interest rates.

Bank reserves and FOMC operations present another significant obstacle for the Fed as it assesses the feasibility of raising interest rates. Prior to 2008, bank excess reserves were approximately $2 billion. When the economy experienced a recession in 2008, the Fed engaged in QE to spark economic growth. It took three rounds of QE to jumpstart improvements in the economy. As a result of QE, the Fed created excess bank reserves of approximately $2.5 trillion. Before 2008, the Fed could easily adjust the FFR through small volume purchases and sales of government securities. After the recession in 2008 and the three rounds of QE, the Fed is faced with two issues: how to manage their balance sheet with the significant amount of USTs and MBSs purchased during QE and how to adjust the FFR while bank reserves and the Fed balance sheet have ballooned during QE. The Fed has the option to make large volume transactions of USTs and MBSs to adjust the FFR and interest rates. Large volume transactions by the Fed are unlikely due to the potential spike in yields of USTs and creating distress among holders of MBSs. The other option for reducing the balance sheet of the Fed is to slowly reduce the amount of money it reinvests into USTs and MBSs as they mature, releasing these securities back into the open market where buyers can purchase them. According to Simon Potter, Executive VP of the NY Federal Reserve Bank, this will be the primary method for lowering the Fed’s balance sheet and normalizing interest rates since the securities the Fed purchased have varying maturities. Simon Potter also noted that lowering the Fed’s balance sheet and excess reserves at banks could potentially take several decades to accomplish. In the meantime the Fed is currently testing the feasibility of using the interest on excess reserves (“IOER”) rate and engaging in overnight reverse repurchase agreements (“ON RRP”) to adjust the FFR while national excess reserves are approximately $2.5 trillion. The IOER rate is the rate of return paid by the Fed for riskless overnight deposits made by banks held at the Fed. If all money market participants are eligible to access IOER, rates would move money market rates up to at least the level of the IOER rate. Even without universal access to IOER rates, competition would push money market rates close to or possibly above the IOER rate. As a result, banks would have an arbitrage opportunity to borrow money at a lower rate and deposit it with the Fed to earn a higher IOER rate. The arbitrage action by banks would establish the IOER rate as a “floor” below short-term interest rates allowing the Fed to achieve its goal meeting the target rate for the FFR despite high excess reserves. An ON RRP is an agreement where the Open Market Trading Desk (“the Desk”) at the Fed sells a security to an RRP counterpart bank with the agreement to buy back the same security at a specified price at a specified date in the future. The difference between the sale price and future purchase price in the RRP, in conjunction with the time

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duration between the sale and future purchase price creates an implied interest rate. The Fed is planning to use both ON RRPs and IOER rates to adjust the FFR during periods of time while the excess reserves at the Fed and banks remains high until the unwinding of QE is complete.

The Fed also has to consider the psychological impact on the stock market and the economy when attempting to raise interest rates. The stock market reacts to perceptions of overall health of the economy based on what the Fed says and does as well as future expectations. Interest rates are directly linked to the money supply in the economy. The amount of money supply available to consumers spending, borrowing and investing habits is tied to GDP, a numerical indicator of the health of the economy. A low interest rate set by the Fed sends the signal to the market that the economy is healthy and encourages spending, borrowing, and investing. A rising interest rate sends a contradictory message to the market to slow spending, borrowing, and investing. Even a spoken word by the Fed about movement in interest rates affects the stock market and public perception of the relative strength of the U.S. economy. Additionally, valuation analysis of securities plays a role in market performance. Investors are constantly adjusting risk free rate and real rate of return in Discounted Cash Flow models to evaluate equities in the market which trade on expectations of future earnings and their spread of expected risk free rate and real rate of return. Perceptions and future expectations can dramatically sway the performance of the market.

The threat of inflation presents another obstacle the Fed has to account for when considering the timing for an increase in the interest rate. Inflation is a function of the supply and demand for money where producing relatively more dollars causes the value of each dollar to decline thus making the level of prices increase making goods and services more expensive to purchase. Inflation has an impact on investors that buy and sell equity based and fixed income securities. Inflation has a two-fold impact on growth and value stocks. For growth stocks, inflation has a negative impact where investors might over-estimate future earnings associated with growth stocks and misprice them. Value stocks are negatively impacted by inflation due to lower corporate profits resulting from higher input costs. Fixed income investors rely on interest paid from a nominal coupon rate stated on securities like bonds and preferred stock. Inflation erodes the nominal coupon rates and reduces the “real” interest earned on fixed income securities. As a result, investors that typically rely on fixed income securities are forced to pursue other investment opportunities with higher risk than they are normally willing to accept to meet their desired return from investments. Inflation potentially becomes an issue if the interest rates are too low for an extended period of time. Currently, the FFR has been set at 0.25% since the recession in 2008. Inflation can have positive and negative effects on the economy. The positive impacts of inflation are adjustments of wages, increase growth and avoid deflation. A moderate rate of inflation allows companies to increase relative wages of employees to offset the rise in the cost of living. Additionally, a steady increase of inflation to a moderate level also boosts economic growth by providing consumers with more money to purchase goods and services, which leads to more production by businesses, increases in profits, business expansion and more employment. Finally, a level of inflation under 6% helps an economy avoid deflation.

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Deflation is a fall in prices which is harmful to an economy. Lower growth and a recession is possible with a fall in prices since consumers are reluctant to spend money on goods and services based on the assumption that future prices will be lower causing a delay in purchases. Deflation causes the “real” value of debt to increase and reduces consumer discretionary income. There are negative effects of inflation on an economy as well. Growth resulting from moderate levels of inflation is typically hard to sustain, leading to periods of boom or bust economic cycles that can damage an economy. High inflation can cause a decrease in investment and long-term growth resulting from uncertainty in the economy. Inflation can also make an economy un-competitive by increasing the cost of exports and shifting demand to cheaper local alternatives. Finally, inflation can reduce the value of savings as the value of money falls. Savers are worse off if the rate of inflation is greater than interest rates. The Fed has stated on numerous occasions that it is seeking a moderate level of inflation in the U.S. economy around 2-3%.

Periods of Rising Interest Rates

The primary tool the Fed continues to utilize to balance interest rates is FOMC operations. FOMC is the process of buying and selling government securities to change the levels of the money supply in bank reserves (i.e. money available for lending). An increase in reserves lowers the FFR, while a tightening of bank reserves raises the FFR. During the last 20 years, the Fed has increased the FFR using FOMC four different times. All of the FFR increases were pre-recession of 2008. Since the recession, the Fed has not raised interest rates, but speculation of an increase is possible in late 2015 or early 2016. The following chart is a quick breakdown of the four most recent time periods when the Fed increased the FFR and how much it increased:

Time Period % Change in FFRFeb. ’94 – Mar. ‘95 2.73%Jan. ’97 – May ‘97 0.32%July ’99 – July ‘00 1.55%June ’04 – Aug. ‘06 4.22%

Modern investing is evolving from the traditional portfolio of 60% equities and 40% bonds, to incorporate more diversification to include alternative assets. The inclusion of alternative assets into portfolios are providing stability, increasing returns and lowering risk during times of both bull and bear stock markets. In addition to the four recent periods of rising interests, 13 indexes have been analyzed (equities, bonds, and 11 alternatives). The same indexes were discussed in a previous white paper “New Market Realities with Alternative Assets in the Efficient Frontier.” Each index represents equities, bonds, and alternative assets. Below is a list of the indexes:

Assets S&P 500 CS Leverage Loan Index

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Barclays Agg. Bond Index CS Long / Short Index CS Conv. Arbitrage Index CS Multi-Strategy Index CS Event Driven Index NCREIF Property Index CS Global Macro Index Bloomberg Commodity CS Hedge Fund Index

The following analysis focuses on the four recent time periods where the Fed increased the FFR, the best / worst performance of 13 indexes, the best / worst volatility of the alternative assets and an explanation of how each index responds in different rising interest rate environments.

2.73% increase in FFR / Feb. ’94 – Mar. ‘95

This time period marks the first time in the last 20 years that the Fed increased the FFR. In the early to mid-90’s concerns of potential inflation arose in the U.S. economy. A sharp increase in interest rates in November 1993 prompted a swift response from the Fed in February ‘94 to March of ‘95 raising the FFR from 3.25% to 5.98. The following displays the average monthly returns during the 14 months of FFR increases.

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Avg. Monthly Returns during FFR increase

S&P 500 Barclays Agg. Bond USCS Conv. ArbitrageCS Event DrivenCS Global MacroCS Lev. LoanCS Long / ShortCS Multi-StrategyNCREIF PropertyBloomberg CommodityCS Hedge Fund Index

Rising Interest Rate period Feb. '94 - Mar. '95

The above chart showcases the average monthly returns for 13 asset classes. From Feb. ’94 – Mar. ’95 the top performing assets were the S&P 500, CS Leveraged Loans, and NCREIF Property. The S&P 500 posted average monthly returns of 0.56%, compared to CS Leveraged Loans at 0.76%, Bloomberg Commodity at 0.99% and NCREIF Property at 2.32%. In contrast, the CS Conv. Arbitrage, CS Global

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Macro, CS Long / Short and CS Hedge Fund Index all had average returns of -0.49%, -0.15%, -0.45%, and -0.24% respectively. Both Barclays Agg. Bond US and CS Event Driven posted average monthly returns close to 0%.

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Top 3 performing Alts. volatility during FFR increase

CS Lev. Loan

NCREIF Property

Bloomberg Commodity

The top three performing alternative assets during the interest rate increase of Feb. ’94 through Mar. ’95 were CS Leveraged Loans, NCREIF Property and Bloomberg Commodity. The volatility measured in Standard Deviation represents the positive and negative fluctuations of the monthly total returns for each alternative during interest rate increase. NCREIF Property and CS Leveraged Loans had average monthly returns of 2.32% and 0.76% with a corresponding volatility of 0.37% and 0.38%, respectively. Bloomberg Commodity had an average monthly return of 0.99% and the highest volatility of 1.96%. In addition to the top performance of NCREIF Property, CS Leveraged Loans, and Bloomberg Commodity, there are alternatives that performed poorly relative to other alternative assets. The chart below showcases the volatility of the bottom three alternatives during the 2.73% increase in the FFR during Feb. ’94 – Mar. ’95. With the Fed increasing the FFR from 3.25% to 5.98%, CS Conv. Arbitrage, CS Long / Short and CS Hedge Fund Index all produced negative average monthly returns and mostly above average volatility of 1.23%. CS Conv. Arbitrage had an average monthly return of -0.49% and volatility of 0.96% which was slightly below the average of 1.23%. CS Long / Short and CS Hedge Fund Index posted average monthly returns of -0.45% and -0.24% and volatilities of 1.92% and 1.94%, respectively.

0.32% Increase in FFR / Jan. ’97 – May ‘97

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In January of 1997 the Fed responded to an Asian and Russian market crisis by increasing the FFR from 5.18% to 5.50%. The rise in the FFR was a result of an epidemic of currency devaluations triggered by the government of Thailand deciding to no longer peg its local currency to the Dollar. The Asian market crisis eventually spread to the Russian economy. Russia experienced declining productivity, a fixed rate of exchange between the Ruble and other foreign currencies and massive government deficits. In order to stabilize the U.S. economy amid these crises, the Fed increased the FFR 0.32% to strengthen the Dollar. The following chart shows the average monthly returns for each of the assets during the Fed’s five month increase of the FFR.

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Avg. Monthly Returns during FFR increase

S&P 500 Barclays Agg. Bond USCS Conv. ArbitrageCS Event DrivenCS Global MacroCS Lev. LoanCS Long / ShortCS Multi-StrategyMSCI ACWI EnergyNCREIF PropertyS&P Global GoldBloomberg CommodityCS Hedge Fund Index

In this chart each asset performed well during the 0.32% increase of the FFR instituted by the Fed in early 1997 with the exception of S&P Global Gold. The top three asset classes for this period were the S&P 500, CS Global Macro, and MSCI ACWI Energy. The average monthly returns for the S&P 500, CS Global Macro, and MSCI ACWI Energy were 3.00%, 2.36%, and 2.26% respectively. The worst performing asset classes were Barclays Agg. Bond US, NCREIF Property and S&P Global Gold. Barclays Agg. Bond US and NCREIF Property had average monthly returns of 0.38% and 0.84%. From Jan. ’97 – May ‘97, the S&P Global Gold posted the worst average monthly return of -3.16%. Barclays Agg. Bond US also posted another average monthly return close to zero.

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Rising Interest Rate period Jan. '97 - May ‘97

Jan-97 Feb-97 Mar-97 Apr-97 May-97-6.00%

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Top 3 performing Alts. volatility during FFR increase

CS Global Macro

MSCI ACWI Energy

CS Hedge Fund Index

This chart highlights the top performing alternative assets during the FFR increase of 0.32% from Jan. ’97 – May ’97. The average volatility for the alternative assets from Jan. ’97 – May ’97 is 2.38%. CS Global Macro and MSCI ACWI Energy had the highest average monthly returns and corresponding volatility at 2.36%, 2.26% and 4.17%, 3.79% respectively. The CS Hedge Fund Index had volatility slightly below the average at 2.28% while posting average monthly returns of 1.82%. The S&P Global Gold, CS Leveraged Loan and NCREIF Property were the worst performing alternative assets during the same period of rising interest rates. S&P Global Gold had the lowest average monthly return at -3.16% coupled with the highest volatility of 10.32%. Both CS Leveraged Loan and NCREIF Property had the lowest volatility at 0.14% and 0.08%, but managed positive average monthly returns of 0.74% and 0.84% respectively.

1.55% Increase in FFR / July ’99 – July ‘00

July ’99 – July ’00 marked the third time in the last 20 years that the Fed raised the FFR. During this time the U.S. economy was growing at a rapid pace with no signs of corresponding inflation. Unemployment was hovering around 4.3%, while demand for goods and services was high, and inflation was approximately 1.5%. These combined factors sparked fears that inflation would rapidly approach and the Fed responded by increasing the FFR from 4.99% to 6.54%.

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Avg. Monthly Returns during FFR increase

S&P 500 Barclays Agg. Bond USCS Conv. ArbitrageCS Event DrivenCS Global MacroCS Lev. LoanCS Long / ShortCS Multi-StrategyMSCI ACWI EnergyNCREIF PropertyS&P Global GoldBloomberg CommodityCS Hedge Fund Index

Above is a breakdown of the average monthly returns for each asset class during an FFR increase of 1.55%. For the second consecutive period of FFR increase, each asset with the exception of S&P Global Gold has produced positive returns. The top four assets were NCREIF Property, CS Long / Short, Bloomberg Commodity, and CS Conv. Arbitrage with average monthly returns of 3.89%, 2.30%, 1.92%, and 1.84% respectively. The S&P 500, Barclays Agg. Bond US, and CS Leveraged Loans posted the lowest average monthly returns of 0.51%, 0.42% and 0.33%. The S&P Global Gold again reacted negatively to an increase in the FFR by producing a -1.18% average monthly return.

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Rising Interest Rate period July '99 - July '00

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Top 3 performing Alts. volatility during FFR increase

NCREIF Property

CS Long / Short

Bloomberg Commodity

The above chart represents the volatility of monthly returns during the FFR increase of July ’99 – July ’00 for the top three alternative assets. NCREIF Property had the highest average monthly returns of 3.89% and the lowest volatility of 0.34%. Both CS Long / Short and Bloomberg Commodity had positive average monthly returns of 2.30% and 1.92%, however they each produced significantly high volatility. CS Long / Short had volatility of 5.80% and Bloomberg Commodity posted volatility of 3.46%. From July ’99 – July ’00 the bottom performing alternative asset classes were S&P Global Gold, CS Leveraged Loan and CS Global Macro. CS Leveraged Loan and CS Global Macro each produced average monthly returns under 1.00%, while S&P Global Gold posted -1.18%. During this period of increasing FFR, S&P Global Gold and CS Global Macro had the highest volatility of 9.77% and 3.91%, respectively.

4.22% Increase in FFR / June ’04 – Aug. ‘06

In 2004, the U.S. housing market was experiencing a significant increase in demand, new construction, and financing. Investors began to fear the possibility of a housing market bubble due to the rapid growth. The Fed responded accordingly, and increased the FFR from 4.99% to 6.54% in an attempt to slow the rate of growth for the economy. The following chart details the performance of the asset classes from June ’04 – Aug. ’06.

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Avg. Monthly Returns during FFR increase

S&P 500 Barclays Agg. Bond USCS Conv. ArbitrageCS Event DrivenCS Global MacroCS Lev. LoanCS Long / ShortCS Multi-StrategyMSCI ACWI EnergyNCREIF PropertyS&P Global GoldBloomberg CommodityCS Hedge Fund Index

The time period of June ’04 – Aug. ’06 marks the last time the Fed has raised the FFR during the past 20 years. All of the assets produced positive average monthly returns during the FFR increase from 1.03% to 5.25%. The best performing assets were NCREIF Property, MSCI ACWI Energy, S&P Global Gold, and CS Long / Short. NCREIF Property outperformed all the assets by a considerable margin with an average monthly return of 5.97%. MSCI ACWI Energy, S&P Global Gold, and CS Long / Short posted average monthly returns of 2.45%, 2.34%, and 1.26% respectively. Barclays Agg. Bond US., CS Conv. Arbitrage, and CS Leveraged Loans were the bottom performing asset classes from June ’04 – Aug. ’06. All three produced average monthly returns below 1.00%.

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Rising Interest Rate period June '04 - Aug. '06

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Top 3 performing Alts. volatility during FFR increase

NCREIF Property

MSCI ACWI Energy

S&P Global Gold

This chart showcases the volatility for the top three performing asset classes during the final increase of the FFR by the Fed in June ’04 – Aug. ’06. NCREIF Property produced the highest average monthly return of 5.97% and the lowest volatility of 1.16%. Both MSCI ACWI Energy and S&P Global Gold had returns of 2.45% and 2.34% respectively. Additionally, MSCI ACWI Energy and S&P Global Gold posted the highest volatility from June ’04 – Aug. ’06 at 5.55% and 8.45%. During this period of a rising FFR, the worst performing assets were CS Conv. Arbitrage, CS Leveraged Loan, and CS Multi-Strategy. All three of these assets produced average monthly returns of less than 1.00%, but also had extremely low volatility of 1.17%, 0.18% and 1.00% for CS Conv. Arbitrage, CS Leveraged Loan, and CS Multi-Strategy respectively.

All of the indices analyzed in this paper have performance and risk profiles that behave differently given changes in the interest rate environment. The following summarizes each asset’s performance and risk during the last four periods of rising interest rates.

S&P 500

The S&P 500 typically responds unfavorably to increases in the FFR, despite not being directly impacted by the change. An increase in interest rates affects the behavior of businesses and consumers. Businesses are affected by an increase in interest rates by impacting their cost of borrowing which lowers revenues. A company’s valuation can also be affected by a decrease in future cash flows based on the perception that a company is cutting growth spending, experiencing higher debt expenses and receiving lower revenues from consumers. A rising interest rate also impacts the amount of disposable money a consumer has to spend, which decreases a company’s bottom line. Below is a quick table of

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how the S&P 500 performed during the last four FFR increases. The S&P 500 has moderate volatility and very low average monthly returns.

S&P 500Time Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% 0.56% 2.92%Jan. ’97 – May ‘97 0.32% 3.00% 4.11%July ’99 – July ‘00 1.55% 0.51% 4.29%June ’04 – Aug. ‘06 4.22% 0.74% 2.07%

Barclays Agg. Bond US

The Barclays US Bond market, similar to the S&P 500 performs poorly in periods of rising interest rates but for different reasons. Fears and uncertainties surrounding interest rates are the biggest factors for bond performance. The ideal market for bonds is with a high and stable FFR. As investor fears rise, money flows from the S&P 500 to the bond market. The demand and yield for bonds during periods of rising FFR is low, due to uncertainty of where the FFR will rise to and stabilize. The table below highlights how the Barclays US Bond market reacted during the last periods of an increasing FFR. The bond market has very low average monthly returns and low volatility (i.e. volatility of monthly returns during FFR increase) during periods where the Fed has raised the FFR.

Barclays Agg. Bond USTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% 0.05% 1.42%Jan. ’97 – May ‘97 0.32% 0.38% 0.87%July ’99 – July ‘00 1.55% 0.42% 0.79%June ’04 – Aug. ‘06 4.22% 0.34% 0.84%

CS. Conv. Arbitrage

Convertible Arbitrage is a market neutral strategy that seeks to capitalize on pricing inaccuracies between convertible bonds and their underlying stock with minimal volatility. Changes in interest rates are a major factor in determining the strategy’s performance. Typically, Convertible Arbitrage responds negatively to environments where FFR is increasing. Rising interest rates add to the difficulty to accurately assess bond pricing relative to underlying stock to take advantage of pricing discrepancies. The table shows a mixed performance of average monthly returns during periods of an increasing FFR, while maintaining a low volatility.

CS Conv. ArbitrageTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% -0.49% 0.96%Jan. ’97 – May ‘97 0.32% 1.20% 0.27%July ’99 – July ‘00 1.55% 1.84% 1.06%June ’04 – Aug. ‘06 4.22% 0.27% 1.17%

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CS. Event Driven

Event driven strategy is very similar to Convertible Arbitrage in that it attempts to capitalize on pricing inefficiencies of a company’s stock. Event driven strategies seek out corporations that are experiencing an event such as a merger, acquisition, capital re-structuring, distressed financing, or a bankruptcy. Event driven strategies are market neutral, so increase in the FFR does not have a direct effect on performance. A rising FFR changes what types of corporate events the strategy will seek to take advantage of. Performance hinges on an individual asset manager’s ability to implement the strategy. As evidenced below, the event driven strategy has a low volatility during rising FFR, and low to moderate average monthly returns depending on the asset manager.

CS Event DrivenTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% 0.07% 0.96%Jan. ’97 – May ‘97 0.32% 1.44% 1.07%July ’99 – July ‘00 1.55% 1.01% 1.04%June ’04 – Aug. ‘06 4.22% 0.98% 1.04%

CS Global Macro

A global macro strategy concentrates on taking long and short positions in equity, fixed income, managed futures and currency on a global scale. Global macro strategy performs momentum trading based on analysis of global economic trends. Changing interest rates can have a significant impact both positive and negative on the global macro strategy. The success of the strategy depends on an individual asset manager’s ability to analyze economic trends and make trades in line with the timing of the trend itself. The following table shows a very mixed average monthly return performance linked to correctly timing trends and high volatility attributed taking positions in risky assets such as managed futures and currency.

CS Global MacroTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% -0.15% 2.58%Jan. ’97 – May ‘97 0.32% 2.36% 4.17%July ’99 – July ‘00 1.55% 0.60% 3.91%June ’04 – Aug. ‘06 4.22% 0.83% 1.08%

CS Leveraged Loan

Investment in a leveraged loan strategy involves purchasing single or groups of senior secured floating rate loans. The interest rate on leveraged loans is adjusted or “floated” quarterly based on LIBOR. This component provides some insulation to interest rate risk associated with other types of fixed rate debt

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instruments. A leveraged loan strategy usually performs well in periods of rising interest rates. The table below shows leveraged loan performance during the four previous time periods of increasing FFR. The average monthly returns and volatility for leveraged loans are low, but are extremely consistent and non-negative.

CS Leveraged LoanTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% 0.76% 0.38%Jan. ’97 – May ‘97 0.32% 0.74% 0.14%July ’99 – July ‘00 1.55% 0.33% 0.52%June ’04 – Aug. ‘06 4.22% 0.49% 0.18%

CS Long / Short

The Long / Short equity strategy takes positions to capitalize on both upswings and downswings within the equity market. A high correlation exists between the S&P 500 and the Long / Short strategy. An increase in the FFR does not directly affect the Long / Short strategy, it does affect the underlying equity securities it takes positions in. The average monthly returns and volatility of this strategy mirrors that of the S&P 500 as seen in the table below. Like other strategies in the alternative category, success hinges on an asset manager’s ability to navigate changes in the market and implement their investment strategy.

CS Long / ShortTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% -0.45% 1.92%Jan. ’97 – May ‘97 0.32% 0.96% 2.89%July ’99 – July ‘00 1.55% 2.30% 5.80%June ’04 – Aug. ‘06 4.22% 1.26% 2.35%

CS Multi-Strategy

A Multi-Strategy investment strategy combines several alternative asset classes such as the Long / Short, quantitative, fixed income, and event-driven strategies. An increase in the FFR affects which sub-strategies Multi-Strategy will include to provide risk-adjusted return for investors. Multi-Strategy can produce mixed positive average monthly returns and mixed volatility during periods of rising FFR as evidenced in the table. For Multi-Strategy to be successful in periods of rising FFR, the asset manager will have to allocate its assets appropriately in sub-strategies that are least impacted by the changes in the FFR.

CS Multi-StrategyTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% 0.16% 2.47%Jan. ’97 – May ‘97 0.32% 1.21% 0.68%

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July ’99 – July ‘00 1.55% 1.31% 0.95%June ’04 – Aug. ‘06 4.22% 0.73% 1.00%

MSCI ACWI Energy

Energy investing should be negatively affected by an increase in the FFR. A rising FFR strengthens the Dollar and increases the cost of borrowing. The energy industry is known for being a capital intensive industry that relies heavily on credit and debt to fund and expand operations. Higher interest rates and a strong Dollar typically indicate a higher cost of doing business and lower revenues that should lead to a poor performing asset class. However, the table below illustrates strong average monthly returns coupled with high volatility. Investment in energy is challenging pre-conceived thoughts by performing well in periods of a rising FFR, leading to speculation that its performance is tied to global demand compared to interest rates.

MSCI ACWI EnergyTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% N/A N/AJan. ’97 – May ‘97 0.32% 2.26% 3.79%July ’99 – July ‘00 1.55% 0.61% 4.58%June ’04 – Aug. ‘06 4.22% 2.45% 5.55%

NCREIF Property

Investment in real estate has also performed extremely well during periods of an increasing FFR, with the caveat that the rise in interest rates is coupled with an improving economy. The table shows very strong average monthly returns and very low volatility. Rising rates in a healthy US economy will be accompanied by an increase in demand, occupancy, rent, and property valuations. Rising rates in a struggling US economy will result in the contrary. Real estate investment performance will hinge on the health of the US economy during the periods of a rising FFR.

NCREIF PropertyTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% 2.32% 0.37%Jan. ’97 – May ‘97 0.32% 0.84% 0.08%July ’99 – July ‘00 1.55% 3.89% 0.34%June ’04 – Aug. ‘06 4.22% 5.97% 1.16%

S&P Global Gold

Investment in gold performs poorly and is highly sensitive to interest rates during periods of rising FFR. Gold like other commodities sees its value diminish as interest rates increase and investors shift demand to interest paying securities. The table shows mostly negative average monthly returns and extremely

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high volatility during periods of increasing FFR. The ideal environment for gold to produce good returns on investment is low FFR and high investor demand.

S&P Global GoldTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% N/A N/AJan. ’97 – May ‘97 0.32% -3.16% 10.32%July ’99 – July ‘00 1.55% -1.18% 9.77%June ’04 – Aug. ‘06 4.22% 2.34% 8.45%

Bloomberg Commodity

Commodities investing behave similarly to gold where a rising FFR has a negative impact. Commodities decline in value as the FFR increases, and investor’s move towards interest paying investments. Higher interest rates also drive commodity prices and values down by increasing the supply in the economy through higher inventory costs. In the table below, Commodities have produced moderate average monthly returns and high volatility. Commodities, like gold thrive in an environment with a low FFR.

Bloomberg CommodityTime Period % Change in FFR Avg. Monthly Returns Volatility (Std. Dev.)Feb. ’94 – Mar. ‘95 2.73% 0.99% 1.96%Jan. ’97 – May ‘97 0.32% 1.21% 0.52%July ’99 – July ‘00 1.55% 1.92% 3.46%June ’04 – Aug. ‘06 4.22% 0.83% 4.08%

Conclusion

Investment in alternative assets is a great way for investors to seek returns in environments where uncertainty exists surrounding the interest rates, the Fed, and the Federal Funds Rate. Alternative assets can provide stability when rising interest rates threaten portfolio performance. Each of the alternative assets analyzed and discussed in this paper can satisfy investor needs depending on their tolerance to risk. Convertible Arbitrage, Multi-Strategy, and Long / Short strategy produce both mixed returns and volatility during periods of rising interest rates. All three are influenced by changes in interest rates, but their success relies heavier on the individual asset manager’s strategy and ability to execute the strategy in the market. Gold and Commodities are the riskiest of the alternative assets with returns and volatility. Both are equally capable of producing high positive returns and low negative returns during increasing interest rates. Global Macro also produced mixed returns and volatility with changes in interest rates. Similar to Convertible Arbitrage, Multi-Strategy, and Long / Short, Global Macro’s success also depends on an asset manager’s ability to execute their strategy based on economic trends and interest rates. Leveraged Loans produced low positive returns and extremely low volatility during periods of rising interest rates. The floating rate associated with Leveraged Loans allows it to

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move with interest rates keeping its volatility and returns low, but consistent. Event Driven strategy can produce moderate returns and low volatility, but again rely on an asset manager’s ability to execute in the market in addition to interest rates. Real Estate investing performed with the highest returns and lowest volatility of all the alternative asset classes. Real Estate should continue to excel during periods of rising interest rates provided that the increase in interest rates is coupled with a healthy US economy. Energy also produced high returns with more volatility compared to Real Estate. While most conventional thought argues that rising interest rates negatively impact energy, the data disagrees. Energy can continue to produce strong returns so long as global demand is equally strong. Investment in alternative assets may be the answer to questions of uncertainty.

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