Can liquid alternatives fill portfolio gap?

This article is part of
Investing in Alternatives – September 2016

Can liquid alternatives fill portfolio gap?

The macroeconomic headwinds and elevated volatility currently serving as a cornerstone for much of the prevailing investor uncertainty show little sign of receding.

The Brexit vote and the ensuing political and economic upheaval only amplify the uncertainty.

Traditional assets can no longer be relied upon to behave properly, with the relationship between stocks and bonds breaking down so far this year. This calls into question the role traditional assets have historically played as diversified sources of return in a balanced portfolio, with investors realising that what’s worked in past years will not work in the future.

Article continues after advert

Government bonds are not the only example of this conundrum, but they are one of the more acute. Once the undebated bastion of safety for a traditional balanced portfolio, they’re undergoing a secular shift, with yields too low for them to provide an income stream.

Nearly one-third of global government bonds today are locking in a capital loss for investors who hold to maturity. It’s even more extreme when considering real returns, as the yield on many government bonds are below the current level of inflation in their country and far beneath their central bank inflation targets.

With traditional assets failing in their capital preservation and portfolio stability purposes, investors need to look for something else to help offset the risk generated by equities. Demand to generate returns that are not beholden to the direction of asset markets has become more pronounced.

Investors are essentially striving for a balance – exposure that distances them from market risks, but that can still offer the growth to meet long-term financial goals given that we remain in a low-return world of mediocre economic momentum and rock-bottom interest rates.

Hedge funds are broadly known for helping to control downside risk but have historically been the preserve of institutional investors – whether due to transparency, liquidity, access or costs. Meanwhile, rapid innovation in Ucits has seen tremendous growth in the availability of liquid alternative investment strategies, which offer some of the characteristics of hedge fund exposure in more liquid, cost-efficient and regulated vehicles.

In 2008, there were fewer than 300 alternative Ucits in Europe – today there are more than 1,300. Despite this, these funds represent only about 5 per cent of the number of overall Ucits in Europe, suggesting there is more room for growth.

Multi-manager liquid alternative strategies, which allow retail investors to tap into diversified hedge fund exposure with daily liquidity, have been viewed as a source of less-correlated returns. Contrary to popular belief, these strategies do not intend to give investors a roller-coaster ride with the type of annualised returns that will shoot the lights out. Instead, the emphasis is on targeting risk-adjusted returns with low volatility and low beta to broad markets through multiple market cycles, by isolating idiosyncratic risk and focusing on relative value opportunities. Capital preservation is also inherent, with the onus placed on robust risk management and drawdown protection.