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Equities Are Just About the Only Game in Town

With serious challenges facing fixed income and commodities, investors need to get creative to hedge this exposure to equities in 2015.

Here's the good news: As investors think about where to put their money to work this year, there's still a strong case for equities, particularly those in the United States, which enjoyed total returns of 14 percent in 2014. Now for the bad: There are precious few opportunities in other asset classes. Not only are yields low across much of the fixed-income universe, the Federal Reserve is widely expected to raise interest rates in 2015. Commodities offer cold comfort, too. The dramatic drop in the price of crude oil (59 percent for Brent and 55 percent for West Texas Intermediate) over the past seven months has been covered at length here and elsewhere, but other commodities have fared badly, too. In 2014, total returns for the industrial metals aluminum and copper, were down 3 percent and down 17 percent, respectively. Precious metals fared no better, with gold down 2 percent and silver down 20 percent.

Investors Are Sticking to Equities

The lack of viable options in other asset classes leads Credit Suisse's Private Banking & Wealth Management division to suggest that investors stick with equities and diversify via market-neutral and long-short strategies. Both approaches aim to minimize exposure to big market swings by playing one stock or a set of stocks against another, with investors buying those they expect to rise and shorting those they believe will fall, based either on technical factors or more fundamental trends affecting individual companies. Typically, the two sets of stocks in play belong to the same sector, region, or currency.

Market-Neutral Versus Long-Short Strategies 

The difference between market-neutral strategies and long-short strategies is one of calibration, says Michael O'Sullivan, Credit Suisse Chief Investment Officer for the United Kingdom, Eastern Europe, Middle East and Africa in the Private Banking and Wealth Management Division. As the name implies, market-neutral strategies aim to eliminate any exposure to moves in the broader equity markets, with short positions balancing long ones. Long-short strategies, on the other hand, tend to be more exposed to moves in the market, with most poised to benefit from markets moving higher. "Markets tend to go up over time and it's both more difficult and more expensive to find short assets than long ones," O'Sullivan explains.

Hedge Fund Barometer Signals Green or Hedge Fund Barometer in the Green Area

While individual investors can certainly puzzle it out on their own, the easiest way to pursue either of these strategies is through a hedge fund that specializes in them. True, hedge funds haven't been able to outperform the bull market in recent years, having returned just 4.13 percent in 2014, but Credit Suisse's proprietary Hedge Fund Barometer signals favorable conditions ahead, based on the state of the business cycle, systemic risk, volatility, and liquidity.

Volatility is Slowly Returning

With regard to the business cycle, although the U.S. is the lone driver of global growth at the moment, global industrial production momentum accelerated at the end of 2014 and Credit Suisse economists believe it will continue to speed up in 2015. There are few signs that hedge fund managers are crowding into the same trades, which indicates low levels of systemic risk. After major spikes in October and December, volatility has settled back down to historic lows. Importantly, however, O'Sullivan says that although the market won't experience the wild volatility swings typical of a market correction, there will be a few more bumps than in years past – and that's a good thing.

Markets Are at the Cusp of Change

"What has really made life difficult for hedge funds in the last two to three years is that central banks have been such a major player in the market," he says. "Quantitative easing has absolutely killed volatility and changed the way markets move. Many hedge funds need volatility of some sort to be able to make returns. I think it's too early to tell, but we could well be on the cusp of a change if central banks – the Federal Reserve in particular – continue to disengage." But a move from the Fed would also likely dry up some liquidity, so the fourth metric the Hedge Fund Barometer tracks is flashing a yellow caution light. All in all, however, investment conditions are squarely in positive territory.

Careful Selection is Key

Stock pickers also might regain some advantage going into 2015. Share prices are no longer moving up and down in lockstep as they did during the financial crisis, creating more opportunities for stock pickers to spot undervalued or overvalued companies. "With few tantalizing investment options in other asset classes, careful selection within the world of equities is one of the best ways to find both diversification and outperformance in the year ahead," says Fan Cheuk Wan, Credit Suisse Chief Investment Officer for the Asia Pacific in the Private Banking and Wealth Management Division.

This article has originally appeared in The Financialist.