Alternatives’ role in generating a new source of return

There’s a widely available asset class that historically outperforms stocks when equities decline and bonds when interest rates rise. Most investors don’t own it, however, perhaps because they don’t know what it is, or they may be scared off by terminology.

Liquid alternatives are mutual funds and exchange-traded funds that follow alternative or hedge fund-like investment strategies. Probably the best way to understand an alternative investment strategy is to understand what it does. It seeks to provide a new source of return compared with stocks and bonds and reduce overall portfolio risk.

We believe finding a way to generate returns is top of mind for many advisers right now, in light of recent stock market volatility and potentially rising interest rates. Consider, then, the compelling case for alternatives.

TOP OF MIND

Since 1990, there have been five periods when the S&P 500 fell 15% or more and five periods of rising 10-year Treasury rates. The HFRI Fund of Funds Composite Index, which represents a diversified basket of hedge fund strategies, outperformed the S&P 500 by an average of 23 percentage points during the five stock market declines, and outperformed the Barclays Aggregate Bond Index by an average of 16 percentage points during the periods of rising rates (with positive performance each time).

While hedge fund indexes go back 25 years, liquid alternatives are relatively new. Unfortunately, there aren’t widely accepted benchmarks to gauge performance. We could use mutual fund data providers’ category averages, but there are 15 of them. And within each category, there are funds that follow completely different strategies, many of which may not be “alternative” by the two criteria given above.

At Goldman Sachs Asset Management, we set out to make life a little easier for advisers interested in finding and tracking liquid alternative investments. We took the universe of 642 so-called alternative mutual funds (as of June 30), and narrowed it down to approximately 300 funds that we believe can potentially provide returns that are different than those of stocks and bonds (as defined by beta and correlation to major stock and bond indexes), and reduce portfolio risk (as defined by a minimum shorting/hedging threshold).

After combing through each fund’s publicly available information, we then categorized the approximately 300 alternative funds into five categories or peer groups, the same ones used by hedge fund databases and institutional investors. The five peer groups are intended to help advisers construct diversified portfolios of liquid alternatives; four are single strategies, to use in building customized solutions, and the fifth is multistrategy, for advisers seeking a pre-packaged, diversified alternatives basket. The constituents of each peer group are available to advisers to run their own due diligence.

The table above shows how liquid alternatives actually performed in the recent bout of volatility — the July-August 2015 market turmoil. All five GSAM LAI peer groups outperformed the S&P 500 and a more diversified 60/40 portfolio, in some cases by a wide margin.

THE HEDGE FUND EQUATION

In addition, a diversified basket of liquid alternatives, as represented by the GSAM LAI Multistrategy Peer Group, has performed similarly to hedge funds over the past three and five years. It stands to reason, then, that liquid alternatives may provide return benefits similar to hedge funds over longer periods, especially during equity market turmoil or rising rates. So in our opinion, don’t let their name stand in your way.

Nadia Papagiannis is vice president of alternative investments at Goldman Sachs Asset Management.