Liquid alternative

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Liquid alternative

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.

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.

This is why absolute return strategies should be incorporated into traditional portfolios.

Depending on investors’ specific needs, absolute return solutions have the potential to provide:

1. A source of Alpha – to complement the core portfolio aiming to achieve desired investment outcomes

2. A hedge to a traditional asset allocation – seeking to insulate the overall portfolio against adverse market moves

A pro-rata allocation from equity and fixed income exposures to liquid alternatives may result in a meaningful improvement in a portfolio’s risk and return profile and portfolios should be better equipped to achieve lower correlations to market returns (beta), lower volatility and contain drawdown.

Absolute return strategies may complement traditional asset allocations. By allocating a portion of a traditional balanced portfolio’s exposure to these strategies, which have the potential to generate attractive returns independent from prevailing economic conditions, investors may experience the potential for more stable and higher risk-adjusted returns over time.

They also have the flexibility to offset their beta exposures during periods of declining market returns, which may allow them to contain the drawdowns experienced by both equity and bond markets.

In conclusion, there has been some turmoil across several asset classes this year – including bonds, emerging markets and commodities. For investors looking for uncorrelated returns and enhanced diversification, absolute return strategies can present alpha generating opportunities in such an environment and could play an important role in insulating investors during a period of expected monetary policy tightening, acting as a complement to existing allocation.

Hugh Prendergast is head of strategic product and marketing, Western Europe of Pioneer Investments

Key Points

Absolute return-oriented strategies have the ability to provide effective diversification.

Developed market equities look at least fully valued, particularly in the US.

the correlation between stocks and bonds is not always stable.