Liquid alternatives are asset classes that exhibit modest to low correlation with traditional equity and fixed income investments. Investors can get exposure to liquid alternatives via broadly available investments that are without the principal lock-ups of asset classes such as private equity and hedge funds.
Liquid alternatives can be further divided into alternative asset classes and alternative investment strategies:
- Alternative asset classes, such as commodities and emerging market currencies, provide exposure to alternative risk premia whose returns are driven by different economic drivers than traditional equity and fix income portfolios.
- Alternative investment strategies, including absolute return fixed income, equity long/short and managed futures, are typically actively managed and not constrained by traditional benchmarks.
Liquid alternatives can provide a few benefits such as daily liquidity (in most vehicles), improved transparency, lower investment minimums, and simplified tax reporting (for U.S. investors), as compared to most semi-liquid and illiquid alternatives.
Incorporating Liquid Alternatives into Portfolios
Incorporating liquid alternative strategies in portfolios substantially expands an investor’s opportunity set and increases his chance of successful outcomes:
- Dedicating a portion of total assets to liquid alternative strategies has the potential to improve risk-adjusted returns, improve diversification, and address tactical market views and concerns.
- Investors can also complement their core benchmark-oriented strategies with absolute return-oriented approaches, which will allow for greater manager flexibility.
Incorporating liquid alternative strategies into a portfolio can be complicated. It requires investors to understand the varied risk characteristics of each liquid alternative or strategy. More importantly, it requires investors to know how the respective key risk characteristics of each category vary across different market environments.
- Equity market-neutral strategies seek to provide limited equity beta by taking equal long and short positions, thereby isolating the alpha component of an equity strategy.
- Long/short equity strategies provide variable equity exposure while allowing for broader management of market risk. A well-managed long/short equity portfolio benefits from the short exposure with improved downside risk mitigation.
- Multi-alternative strategies are designed to achieve attractive risk-adjusted returns with modest volatility and limited downside potential by allocating across a broad range of absolute-return-oriented strategies.
- Managed futures have the potential to generate positive returns by capturing price trends across major asset classes. Historically, managed futures have provided diversification to traditional equity and fixed income portfolios, especially during times of market stress.
- Nontraditional bond strategies invest across global fixed income markets and they have the ability to outperform across all market environments through a combination of active management and trading expertise.
Key Attributes for Liquid Alternative Managers
- Exceptional and proven manager experience and experience in managing mutual funds
- Understanding of the underlying risk factors and the ability to dynamically adjust such exposures within the portfolio as warranted
- Depth of research and a demonstrated ability and process to convert research themes into profitable trades
- A well-defined and repeatable investment process
- A robust risk management framework
- Proper alignment with investor incentives
- Regulatory/compliance processes
- Returns generated in a consistent and diversified manner; strong performance during periods of market shocks
- Trading efficiency (achievable through economies of scale)
- Fees in relation to the value generated