Liquid alternative

Liquid alternative

Against a backdrop of lower returns and higher volatility from traditional asset classes, investors now need to consider new sources of return.

Absolute return-oriented strategies have the ability to provide effective diversification, improve risk-adjusted returns, and act as shock absorbers during times of market stress. They offer investors additional flexibility to long-only allocations, as they remain relatively uncorrelated with global equity and bond markets.

It is an unappreciated fact that many of the world’s most conservative investors are actually now invested in some of the riskiest assets. Even those who have not succumbed to the reach for yield and added to risk could already be losing money. Holders of 10-Year German Bunds lost around 8 per cent from mid-April to mid-June this year alone. They could see more of their capital eroded should rates eventually rise.

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Developed market equities look at least fully valued, particularly in the US, leaving single asset class, balanced, and long-only multi-asset investors facing tough decisions. There are few unexplored areas of the market, where investors can expand their investment universe beyond traditional asset classes.

Breaking it down

Absolute return, or the so-called liquid alternative, strategies may be part of the solution, but what are we talking about exactly?

Alternative investments are commonly identified as a wide array of strategies that aim to generate returns uncorrelated to those associated with traditional equity and fixed income betas. Examples of alternative strategies can include long/short equity and fixed income, global macro and managed futures.

Liquid denotes the ability to transact in a transparent regulated mutual fund (Ucits) generally offering daily liquidity.

As investors are facing lower returns from equities and bonds, combined with a potential rise in volatility, it is time to consider a different way of investing, one that targets new sources of returns, downside mitigation and volatility management.

This is where absolute return strategies come in. They have the potential to preserve capital and may benefit from investment opportunities which traditional investment strategies are not able to explore. By adding diversified sources of return to traditional portfolios, investors may achieve higher levels of wealth accumulation over time.

In addition, correlation dynamics have changed. Historically, investors seeking to grow wealth while trying to insulate their portfolios from changing economic and market conditions sought balance through diversification across stocks and bonds. Exposure to stocks typically generated growth during periods of economic expansion, while exposure to bonds was used to provide capital preservation, typically in periods of contraction. The lack of correlation between these two asset classes seemed to provide sufficient diversification and led to what is referred to today as a traditional balanced portfolio.

However, the correlation between stocks and bonds is not always stable, as highlighted in 2008 when their diversification benefits all but disappeared. Both asset classes underperformed simultaneously during the economic crisis. This was not the first time for such an occurrence, nor was it the last.