by Nicolo Bragazza, associate portfolio manager, Morningstar Investment Management
As bonds failed to provide protection during 2022, investors have thought about alternative ways to diversify their portfolios and for many the answer has been ‘liquid alternatives’. Here, some suggestions for thinking about liquid alts, their role in portfolios and how they behaved in historical market scenarios.
What are liquid alts?
Liquid alternatives (from now on abbreviated as ‘liquid alts’) are vehicles offering exposure to asset classes or investment strategies deemed as alternative to more traditional assets such as bonds and equities with a liquidity profile similar to them. These strategies argue to offer good risk-adjusted returns whilst maintaining lower correlation to both fixed income and equity markets.
The higher degree of liquidity sets liquid alts apart from other alternative investments, such as private equity and direct real estate, and this feature makes access easier for investors unwilling or unable to commit and lock capital in for many years. Liquid alts include liquid hedge funds, commodities and REITs, but this should be not considered as an exhaustive list as some investors might include other asset classes to the list, such as public infrastructure or insurance-linked bonds.
Are categories/classification useful?
Understanding what liquid alts are is key and classification may help in capturing their essential characteristics. However, the classification of liquid alternatives is not a simple one, as funds employ different strategies to achieve their objectives and may invest in different assets. For example, Morningstar has categorized hedge funds in seven categories, including macro strategies, event driven and equity Market Neutral among others.
Other research houses have created other classifications, although generally these share similar characteristics as they usually distinguish among relative value strategies, trend following and more opportunistic such as global macro. Inherently, there is always a degree of arbitrariness in classifications within liquid alts, and, therefore, investors should not fully rely on them as they do not replace the need for proper due diligence.
What is their portfolio purpose?
A useful classification of the use of alternatives in portfolios has been provided in this article. It distinguishes among modifiers, diversifiers and opportunistic strategies. As the name might suggest, diversifiers are strategies with low beta/correlation to traditional markets and factors, i.e. with a primary objective of providing portfolio diversification.
Modifiers instead do not have the same defensive/uncorrelated characteristics and instead focus on changing the return profile by smoothing the performance across different market environments through a combination of downside protection and lower upside beta. Instead, opportunistic strategies stress their being unconstrained to offer a combination of uncorrelated capital growth and drawdown protection. This suggests that a wise use of these different strategies within a multi-asset portfolio may give a chance of improving outcomes on a risk-adjusted basis that may not be achievable by the sole use of “traditional” asset classes.
Historical performance in different scenarios
As with any other asset class, it is important to understand how liquid alts have performed in different market and macroeconomic environments to see if they have delivered on their promises. This should be an essential step for portfolio construction and asset allocation as it helps in setting expectations and clarify the role of alternatives within the broader portfolio context.
Historically, during recessions, global macro and managed futures hedge funds have performed better than other hedge fund categories, including equity market neutral and event driven, and this is consistent with their primary goal of providing portfolio diversification. During the GFC, although their role is still mainly about diversification, equity market neutral and convertible arbitrage suffered with maximum drawdowns above 30%, but they did better than global equities. More generally, however, it seems that hedge funds could not match the defensive abilities of fixed income as represented by the US aggregate in extreme environments.
On the other side, commodities have suffered the most during recessionary environments, with high volatility and sharp drawdowns. Similarly to equity and commodities, REITs have not performed well during recessions and the GFC has been extremely painful for this asset class.
Interestingly enough, during the tech bubble burst in 2001, hedge funds delivered better returns than equities and most hedge fund categories delivered positive returns, with again managed futures and global macro playing the role of best performers. Looking at market scenarios, and specifically to those where the US equity market falls by more than 10% peak to trough, we see confirmed the diversifying role of Global Macro and Managed Futures, whilst commodities fall along with equity markets.
A simple checklist for investing in liquid alts
1. Understand the strategy and the asset class: strategies need to be understood in the broader context of their peers but also with regards to their unique characteristics. A strong understanding of the asset classes where they invest is also required to avoid unintended consequences for portfolios. No ex-ante classification can be a substitute for a proper due diligence.
2. Set realistic expectations: strategies need to be benchmarked appropriately in order to set expectations in terms of their alpha generation and beta against the strategy benchmark.
3. Understand the role of liquid alts in the portfolio from a risk/return perspective: what is the role of the strategy/asset class in the portfolio? Does it bring anything unique, i.e. that cannot be reproduced by other conventional assets? These questions should help in framing the investment case and in clarifying the reasons for inclusion in portfolios as more assets/strategies do not necessarily guarantee higher diversification.
4. Pay attention to costs: to access many alternative asset classes, there is not a wide availability of passive low cost vehicles. Therefore, cost considerations are very important and avoiding paying high fees should be the first step to reduce the risk of investors being disappointed by alts.
Liquid alternatives performance
| Scenarios | US Reits | S&P GSCI TR USD | Managed Future | Long/Short equity | Multi-Strategy | Convertible Arbitrage | Equity Market Neutral | Event Driven | Global macro | Fixed income arbitrage | Hedge funds | USD Cash | Global equity | US Agg |
| Recession | -16.70% | -45.80% | 2.10% | -7.10% | -6.70% | -5.10% | -15.20% | -7.10% | 1.30% | -10.40% | -6.70% | 4.90% | -19.30% | 6.10% |
| US Policy Rate increasing | 11.50% | 2.30% | 2.20% | 8.50% | 6.80% | 4.70% | 4.90% | 6.60% | 5.10% | 4.20% | 6.10% | 3.60% | 10.70% | 2.90% |
| US Equity drawdown >10% | -13.90% | -25.70% | 12.10% | -11.40% | -2.90% | -3% | -4.60% | -09.60% | 3.20% | -4.40% | -7.20% | 4.60% | -31.50% | 7.80% |
| Financial crisis | -60.90% | -38.90% | 14.30% | -14.20% | -15.10% | -20.60% | -29.70% | -12.60% | 1.80% | -20.90% | -12.60% | 6.30% | -44.90% | 5% |
| Tech stock crash | 9.50% | 4.90% | 16.30% | -2.50% | 4.30% | 8.30% | 8.40% | 4.50% | 18.50% | 8.20% | 2.80% | 5% | -24.30% | 10.50% |
| Eurozone crisis | -24.90% | -38.70% | 2.80% | -23.10% | -7.10% | -8.80% | -2.50% | -25.60% | 10.20% | 2.60% | -10.70% | 4.70% | -31.60% | 12.10% |
*The 30% drawdown is referring to the October 2007 to February 2009 period, which is the GFC period. The whole performance data is from Feb 1994 to December 2021 and was sourced from Morningstar Direct.
*All data is sourced from Morningstar Direct data as of 20.04.2023.
