After a decade of disappointing returns, could a greater understanding of their benefits kick start a new era for liquid alternatives. Andrew Holt reports.
Liquid alternatives sound like an oxymoron – an alternative that is liquid. But that seemingly contradictory element has seen such assets become an increasingly popular segment of institutional investment strategies due to the range of benefits they bring to portfolios.
Firstly, they are designed to generate returns from non-traditional alternative sources, while providing more investment flexibility than traditional strategies offer. This includes the ability to take short positions or use leverage, for instance, as well as not having any explicit or implicit benchmark.
Liquid alternatives provide these qualities, often in the form of a mutual fund, giving investors more flexibility to adjust their exposure over time. They also open up the asset class to individual investors.
In terms of categorisation of liquid alternatives, one can differentiate between alternative asset classes – such as currencies, commodities or volatility – and alternative strategies, like equity long short, equity market neutral or managed futures.
On the legal front, liquid alternatives are regulated by UCITS in Europe, the Investment Company Act of 1940 (40 Act Funds) in the US, or corresponding regulations in other jurisdictions that make alter- native investments broadly available to all investors.
The global financial crisis in 2008 was an important moment for liquid alternatives. While some of these strategies were available before the crisis – with some being found in Europe as far back as the early 2000s – access to such strategies was limited for most investors due to the lack of easily accessible vehicles.
In the aftermath of the 2008 crisis, liquid alternatives expanded significantly. Primarily seen as a response to the stock market crash with an idea of creating portfolio stabilizers that o er the potential to generate attractive risk-adjusted returns and serve as a diversifier.
Since then, the category has emerged and provided a much broader offering than it did in 2008. Popular examples nowadays include equity market neutral, relative value, trend following and alternative risk premia.
“Liquid alternatives can play various roles in client portfolios, depending on what is used as a funding source,” says Mikhail Krayzler, senior portfolio manager at Allianz Global Investors. “That is, which traditional allocation is reduced to invest in a liquid alternative portfolio, clients can use these especially for diversification, risk mitigation and new sources of return.”
There are questions about the best way to incorporate liquid alternatives into an overall investment strategy. This has evolved over the years, from investing in single funds as an element of the broader alternatives category to being carved out as a separate asset class with a pre-specified allocation that could be implemented with a more integrated, multi-strategy approach.
Today, a customized multi-strategy approach is being promoted that seeks to align investment goals with their expected outcomes. This approach allows for a more expansive use of liquid alternatives – complementing or substituting a traditional fixed income and equity allocation. The original aim of diversified incremental returns and risk mitigation remains, but may now lead to even greater effectiveness in a portfolio.
One big advantage of liquid alternatives is, as the name implies, the liquidity argument – investors can easily adjust their exposures if necessary. “Furthermore, most of these strategies are offered in the mutual fund format which makes investment in liquid alternatives much simpler than on the private side,” Krayzler says.
“At the same time, over recent years, we have seen a tremendous growth on the private market side as institutional investors are looking to further diversify their portfolio,” he adds.
Although the history of liquid alternatives since 2008’s global crisis has not been plain sailing, since 2010 liquid alternative funds averaged an annualised gain of 1.66%, placing them behind every fund category going, save for a few specialty groups.
“First of all, it is important to look at this number on a risk-adjusted basis,” Krayzler says. “Even though on absolute terms some liquid alternative strategies generated substantially lower returns than, let’s say, equities, they did so with a much lower volatility and lower drawdowns.”
Krayzler’s point is valid. For example, during Covid liquid alternatives were down 9.5% – if using the HFRX Global Hedge Index as a proxy – while equity markets dived by more than 30%, according to the MSCI AC World. “Thus, liquid alternatives played their expected role as a portfolio diversifier,” Krayzler says.
“Furthermore, given the heterogenous nature of the liquid alternative space it often makes more sense to look at several buckets within liquid alternatives, such as diversifiers, risk mitigators and premium collectors,” he adds. “If we now look at diversifiers, given their ability to take short positions, they were able to deliver even lower downside capture in the crisis scenario, often referred to as ‘crisis alpha’.”
Diversification is consistently cited as an important part of the appeal of liquid alternatives. “At the same time, it’s not just about diversification,” Krayzler says. “Over the last decade, we have experienced an extremely favourable environment for the 60/40 portfolio with equities rising and interest rates falling.”
Which brings us to the current market environment, with its elevated equity valuations and stretched equity positioning by investors, as well as low or even negative interest rates, it’s becoming more and more difficult to generate returns from traditional asset classes.
“Therefore, from our perspective, having a building block in the portfolio that can generate attractive risk-adjusted returns in the current environment is indispensable,” Krayzler says. In such an outlook, liquid alternatives becoming a serious portfolio option is evident.
Institutional portfolios could benefit from liquid alternatives in several ways. “While basically all investors are looking for diversification, there might also be different secondary themes that can incentivise the addition of these strategies to the overall portfolio,” Krayzler says.
“Some investors might be interested in risk mitigation and strategies like ‘trend following’ or ‘convex profiles’ can help achieve these goals, by either protecting from prolonged drawdowns or by offering hedging from tail events,” he adds. “Other investors might be looking for non-directional profiles and utilize strategies like long-short, alternative risk premia or global macro in order to access alternative profiles and limit portfolio’s sensitivity to traditional markets.”
They can complement allocations to other – traditional and illiquid alternatives – asset classes and strategies, by diversify- ing portfolio loadings concentrated on equity, macroeconomic growth and illiquidity risk factors, and by improving expected long-term portfolio returns.
Liquid alternatives can add value in several ways for allocators that do not have the mandate or the resources to put money with hedge funds or private equity firms. “As investors continue to look for ways to increase the liquidity and risk-adjusted performance of their portfolios, liquid alternatives can offer a suitable vehicle to achieve such objectives in a robust regulatory environment designed to enhance investor protection,” says Tom Kehoe, the Alternative Investment Management Association’s global head of research and communications.
This appeal seems to be playing out. A recent survey found that wealth managers are expanding their alternative asset class exposure as a way of earning returns against a backdrop of low interest rates and low bond yields, with a particular focus on liquid alternatives.
This comes after what has probably been a decline in the use of liquid alternatives in the past decade, progressing through to what we see now, which is considered to be a new era for liquid alternatives – a so called “liquid alternatives 2.0” – with institutional investors more educated on the benefits and flaws of alternative strategies, therefore more committed to the strategy over the long term.
The numbers support this outlook. In recent years, the liquid alternative investment market has grown to $873bn (£638bn) from $156bn (£114bn), according to the Chartered Alternative Investment Analyst Association, with such funds now making up 23% of the global hedge fund industry.
“Liquid alternatives have been out of favour for several years, but the market environment could finally be ripe for these strategies to show their worth,” observes a Morningstar research paper, 2021 Global Liquid Alternatives Landscape. “Like all investment styles and approaches whose time in the sun comes and goes, liquid alternatives likely will not remain out of favour as more dramatic market moves provide bigger advantages to those with nimbler tool kits.”
And the main reason why traditional asset classes such as fixed income and equities have done so well since 2010 was that they were strongly supported by one of the longest cyclical recoveries coupled with unprecedented monetary stimulus and expansionary fiscal policies. “As this support might not continue going forward, the case of liquid alternative might be even stronger today than it was before,” Krayzler adds.
Furthermore, liquid alternatives are long-term investments, making them appealing to the longevity needed for pension funds. These assets offer investors the opportunity to further align their interests and participate in a fast-growing area of the alternative investment universe.
In this outlook for pension funds, liquid assets offer a real opportunity. Some may not want to – or have a threshold limit- ing them – invest in illiquid markets, so allocating to a liquid alternative will give such institutional investors exposure to most strategies pursued by hedge funds in a liquid wrapper.
In this way, and regardless of why liquid alternative funds have had a hard time, future market cycles may give investors reasons to reconsider their alternatives allocation. “There have been signs of renewed interest since governments and central banks around the world embarked on unprecedented fiscal and monetary stimulus, and the range of available strategies has expanded,” states the Morningstar research paper.
“In the US, after a period of muted interest and continued outflows, investors are slowly coming back to the asset class in 2021.” Moreover, the current environment is ripe for liquid alternatives. “In an inflationary environment, correlation across asset classes may increase, necessitating a truly differentiated source of returns,” says Morningstar. “To cope with raising inflation, liquid alternatives have several additional levers to pull, from the flexibility to allocate assets to commodities, for instance, to their ability to hedge risks.”
Importantly, liquid alternatives have shown flexibility in adapting to changing market conditions and exploiting new opportunities. “Event-driven and relative value arbitrage strategies have capitalized on the SPACs boom or exploited less developed market inefficiencies. This flexibility allows many liquid alternatives to ride – at their own peril – new fashions and voguish trends,” Morningstar’s report read.
We could, therefore, be seeing a new era of liquid alternatives in liquid alternatives 2.0 – not just a catchy title. Lessons from the financial crisis of 2008 and the Covid pandemic point to liquid alternative strategies helping to mitigate significant tail-risks associated with equity allocations and alleviate concerns over potential funding and liquidity constraints caused by market price corrections and dislocations. All are important factors for institutional investors and could mean investors look to go liquid when it comes to alternatives.