With interest rates near record lows and stock valuations elevated, more investors are considering liquid alternative investments as potential sources of investment returns. We believe the search for a well-balanced, diversified allocation matters — and that the effort to create this allocation can take a number of paths.
What are liquid alternatives?
In our view, liquid alternative investments (LAI) are daily liquid investment strategies that, like hedge funds, seek to deliver: (1) differentiated returns from those of core asset classes (bonds, equities) —returns that can be beneficial during difficult times in core markets; (2) the potential to reduce overall portfolio risk; and (3) the potential to mitigate the effects of severe ‘drawdowns’ (the peak-to-trough decline during a specific recorded period), particularly in equities.
Why diversify an alternatives allocation?
We categorise the liquid alternative investments universe into five categories for selection and evaluation: equity long/short, event driven, relative value, tactical trading/macro, and multistrategy. Using these classifications, in our view, can help investors understand the elements of a well-diversified allocation.
But why take a well-diversified approach in the first place? We stack rank our five categories by returns and find that there is not much persistence of returns across liquid alternative category averages from year to year. For this reason, selecting the top-performing category in a given year, let alone selecting top-performing managers, can be challenging.
For example, in 2010, event driven strategies outperformed the four other peer groups before descending the ranks in three of the four subsequent years. In another example, tactical trading/macro strategies achieved top-performing status in 2014 after trailing all other peer groups for two straight years.
Historically, the performance of the liquid alternative investments peer groups has been difficult to predict. We believe an allocation to a given liquid alternative investments strategy based solely on recent past performance may lead to poor future results.
In order to help investors make sense of the myriad of liquid alternative offerings, we analysed the 642 mutual funds that Morningstar categorises as liquid alternatives to identify those that employed an investment style that we deemed to be “hedge fund-like.” We eliminated funds that used certain non-traditional investment styles that do not closely resemble a “traditional” hedge fund investment strategy. Our elimination process narrowed the universe of liquid alternative investments to 312 funds.
We believe that diversifying across liquid alternative peer groups should be considered when investing in liquid alternatives, since it seeks to avoid the highs and lows of any given year in any given single strategy. How much manager diversification would be needed to mitigate these highs and lows?
Our analysis shows that, a portfolio combining nine funds would have reduced the allocation’s annualised volatility from an average of 6.5 per cent per fund, to slightly more than half that level, 3.7 per cent.
Exhibit 1: Historically, diversifying liquid alternative investments has reduced volatility
Over the period from 1 January 2013 to 31 December 2015, combinations of the single-strategy liquid alternative investment funds that make up the LAI peer groups exhibited lower volatility than individual single-strategy alternative funds.
Adding an increasing number of liquid alternative funds reduced the volatility of returns in our analysis over the period 2013–2015. Notably, in our view, groups of 8 to 12 funds did not sacrifice returns (~4 per cent average annualised) for lower volatility.
Next, we’ll examine in greater detail a few different paths by which investors can search for a diversified allocation.
We see three potential approaches to building such a diversified liquid alternative portfolio.
Build it yourself – One approach investors may consider is to weave several liquid alternative investments into a unified portfolio construction framework. This approach may be attractive for investors seeking to express high-conviction market views or for those who possess deep knowledge of particular strategies and managers. However, we believe that the process of selecting liquid alternative investments requires expertise in the asset class, knowledge of manager capabilities, judgment of manager and strategy risks, and acumen in assessing market dynamics.
Buy it – Another approach investors may consider opting for is pre-assembled packages of alternative investments. This approach, which we term “Buy,” can be carried out via so-called “multimanager” alternative funds.
In this approach, investors effectively seek to partner with an asset manager who carries out many of the tasks associated with building a liquid alternatives allocation. These tasks may include (1) investment manager selection and research, (2) decisions on when to replace a manager, and (3) ongoing due diligence.
Investors’ decision to outsource several tasks commonly associated with building a liquid alternatives allocation, comes with a trade-off: investors do not get a customised allocation. They opt instead for a pre-assembled package of strategies.
Buy and Build – A final potential use of multimanager alternative strategies is what can be termed a hybrid “Buy-and-Build” approach. This approach generally entails deploying a pre-assembled package of diversified liquid alternative investments which is then complemented by one or more high conviction managers whom the investor believes can potentially contribute to specific investment objectives.
The potential benefits of this approach may include the pursuit of a diversified approach to liquid alternative investments with the flexibility to add high-conviction managers or strategies to the allocation—which we view as a middle ground between the “Buy” and “Build” approaches.
We believe multimanager strategies have the potential to help investors pursue additional sources of investment returns and diversify their alternative investment allocations. We have observed that, generally, investors who are new to investing in liquid alternatives frequently opt for the “single package”, which multimanager strategies can represent.
Meanwhile more experienced liquid alternatives investors may use multimanager strategies as a base, which they will compliment with their preferred single strategy alternative funds. The key, in our view, is to understand the potential of liquid alternative investments to offer an additional driver of portfolio returns.
Theodore Enders is head of portfolio strategy, Strategic Advisory Solutions, Goldman Sachs Asset Management