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Written by: Cynthia Crandall | Vice President and Senior Investment Analyst at Envestnet | PMC
Investors have been fortunate to experience one of the longest bull markets on record. However, the recent stock-market surge—manifested by the Dow Jones Industrial Average’s record close above 22,000 points over the summer and the S&P 500 surpassing 2,500 points earlier this month has caused many to question whether or not valuations are stretched. This development, along with expectations of additional interest-rate increases going forward, has cast a favorable light on the downside protection properties of alternative investments.
Liquid alternatives, which provide access to alternative investment strategies in a mutual fund structure, have had positive returns during the most recent bull market over the past eight years, though returns have been muted as compared to long-only products. As a result, some investors and advisors are wary of this asset class. However, while some liquid-alternative strategies may be complicated to understand, there is no reason to be frightened of liquid alternatives as a whole, as they can be a great diversifier in a multi-asset class portfolio and potentially reduce client drawdowns.
Here are three key points to keep in mind about liquid alternatives:
Liquid alts may perform well, but delivering outsized performance isn’t their goal
Some investors and advisors may not be impressed with the performance of the liquid-alternative asset class when they compare its results to those of equities and bonds in absolute terms, but it is their ability to deliver on the downside and diversify that differentiate them from other strategies, as seen when we analyze the Sharpe ratios (which track risk-adjusted performance) of various asset classes. According to Morningstar, the S&P 500 generated an annualized Sharpe ratio of 0.99, 1.43, and 1.14 over the most recent three-, five-, and seven-year trailing periods, respectively. The Barclays U.S. Aggregate Bond Index generated an annualized Sharpe ratio of 0.84, 0.71, and 1.3 over the same time periods. In comparison, as measured by the performance of the Hedge Fund Research Inc. (HFRI) indices tracking individual alternative investment strategies, merger arbitrage funds had annualized Sharpe ratios of 1.28, 1.57, and 1.61 during those time periods; market neutral funds had 1.82, 2.18, and 1.13; event-driven strategies had 0.57, 1.3, and 1.16; and equity hedge generated 0.58, 1.15, and 0.76.
Liquid alternatives’ lower betas and correlations as compared to traditional asset classes can provide a buffer and differentiated source of return in periods of increased volatility and market declines. This is why investors and advisors need to view potential liquid-alternative strategies through the prism of whether or not they enhance the risk profile of the total portfolio, as opposed to whether or not they strictly offer high returns.
Liquid alts vary widely, so due diligence is important
The spectrum of liquid-alternative strategies is a broad one. Long/short equity strategies, for example, are very different from merger arbitrage or managed futures funds, and multi-strategy liquid alternative portfolios incorporate multiple strategies. Furthermore, there is a larger spread between top- and bottom-performing liquid-alts managers as compared to traditional equity and fixed-income managers—and liquid-alternative strategies can be more difficult to benchmark because they incorporate different levels of risk and leverage depending on the manager.
It is incumbent on advisors and investors to educate themselves about the various liquid-alt products available to them before making investment selections. For advisors, learning how to effectively evaluate liquid alternatives is especially important to ensure they have a complete understanding of the full investment universe and tools available to them, since the Department of Labor’s Fiduciary Rule requires that all advice they provide is in the investor’s best interest.
When conducting due diligence on liquid-alt managers, advisors and investors should consider factors like whether or not a manager’s short book has added value to the portfolio, how concentrated the portfolio is, and whether or not the manager has protected client capital during market drawdowns. They should also look at the underlying assets in the manager’s portfolio. What are they holding? Are there liquidity concerns, or any other risks related to the investments? Are they collateralizing their positions? What is the correlation of these assets to equities and bonds, and is there anything in the fund’s portfolio that could decrease the amount of downside protection it provides?
These are all questions that should be answered in order to help identify the best liquid-alt investment options for client portfolios.
Know how much leverage you take on
The Securities and Exchange Commission’s proposed rule to cap registered funds’ exposure to derivatives may or may not come to fruition, but regardless of whether or not it becomes a legal mandate, it has started an important discussion about risk and leverage.
The SEC’s derivatives rule would mostly affect managed futures funds as well as non-traditional funds with higher derivative exposure, as opposed to strategies with less or no exposure to derivatives. Nevertheless, even investors in funds with higher derivative exposure, or investors who are more familiar with derivatives, sometimes don’t fully understand the assets’ underlying contracts—which leads them to underestimate their chosen strategy’s leverage.
However, high leverage doesn’t always involve high risk. Some liquid-alt strategies are able to utilize derivatives to mitigate risk in other parts of an investor’s portfolio. Here again, education and due diligence are vital for helping advisors and investors select liquid-alt strategies.
Liquid alternatives are important for helping investors diversify at a time when equity valuations may be stretched, and potential interest-rate hikes may make it harder to find value in fixed income. As long as advisors and investors understand how liquid-alt strategies are supposed to function as part of a well-diversified portfolio, and how they should properly evaluate liquid-alt managers, they don’t have to be wary of investing in the asset class. Although the prolonged bull market has in some ways placed us in the deep end of the pool, liquid alts can offer investors a “pool float,” so to speak, to help get them through the inevitable dips of every market cycle.