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Written by: Surya Pisapati | Spouting Rock Financial
In light of the recent market volatility, investors have looked to Liquid Alternatives as a source of diversification and tail risk protection. Liquid Alternatives were touted as having “done their job” in the context of asset allocation, as they generated lower downside capture to the broader equity markets.
As one digs deeper into the constituents of the Liquid Alternative market, the differentiation between various sub-strategies comes to the fore. In order to understand this differentiation we have looked at the performance of the Morningstar alternative sub-categories, including the Nontraditional bond category, over the August/September 2015 drawdown and the subsequent run-up during October. Drawdown period refers to peak-to-trough movement of S&P 500 starting from August 17 to September 27 during which it lost 7.44%. Run-up period refers to the recovery from trough starting September 28 through October 31 during which S&P 500 was up 7.85%.
Long/Short equity funds in general tend to have a higher correlation to the S&P 500 compared to other sub-categories. This was proven to be the case during the period under observation as well, as these funds captured more of the market downside than any other category. On the flip side, they also captured the highest percentage of the ensuing recovery, while the dispersion within the group is evident from the 2.23% maximum return and -25.72% minimum return during the drawdown period. This highlights the importance of thorough due-diligence in manager selection when allocating to managers within this group. In other words, understanding the risks that are driving the returns for a particular strategy helps form return expectations during various market scenarios, be it a bull, bear or sideways market.
The other sub-categories have generated returns in line with expectations during both the periods; i.e., average and median returns show a lower capture ratio on the downside as well as on the upside, supporting the lower correlation benefits touted by these strategies.
In conclusion, Liquid Alternatives have been able to deliver the expected performance over the recent drawdown and run up. However, the underlying dispersion between various sub-strategies in terms of the average return as well as the maximum and minimum returns has demonstrated the need for active due-diligence and monitoring by investors across their portfolios.