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Liquid investments are an emerging trend

As concerns over inflation and the fiscal deficit continue to mount, the market has entered a roller-coaster period of opportunities and pitfalls

As concerns over inflation and the fiscal deficit continue to mount, the market has entered a roller-coaster period of opportunities and pitfalls.

Investors concerned about volatility and portfolio diversification have begun to take a closer look at alternative-investment strategies. Historically, long-term returns for alternatives have demonstrated low correlation to returns for stocks and bonds, making them especially attractive for retirement-age investors who may seek to reduce their overall portfolio risk by adding noncorrelated assets to their mix.

But limits on access have prevented most investors from capitalizing on alternative-investment opportunities. Even when alternative assets are available in an appropriate form, large institutions have struggled with the risk and fee variables that can complicate their use.

Key barriers to alternatives investing include high costs, illiquidity and a lack of transparency.

But an emerging trend has brought to the market a number of liquid investments with transparent structures, such as mutual funds, exchange-traded funds and separately managed accounts. These so-called liquid alternatives give mainstream investors the potential to earn strong risk-adjusted results similar to those of hedge funds.

DOWNSIDE PROTECTION

Liquid alternatives offer certain key advantages, including greater liquidity, which empowers investors to benefit from market upside in bullish environments while potentially reducing downside risk during economic crises. They also offer risk-and-return characteristics not found in long-only equity and fixed-income portfolios, and lower fees and no lockup periods.

Liquid alternatives allow advisers to offer clients an element of downside protection, combined with a return stream that is uncorrelated with other major asset classes.

That said, there are challenges.

In order to construct portfolios that maximize liquid alternative-investment strategies, financial advisers need to spend time evaluating their merits and gaining a firm understanding of the products so that they can discuss them comfortably with clients. In doing so, they should ask themselves a few fundamental questions, such as: “What percentage of assets should be allocated to alternatives in the overall portfolio?” or “Which sub-strategies should we include? How should we combine them? Which managers should we use?”

In the past, alternative-asset managers thought that their investment strategies shouldn’t be categorized in the same manner as traditional long-only, fundamentals-based strategies. Instead, they built portfolios based on arbitrage opportunities, when securities were temporarily mispriced, and sought to expand their tool box of investing instruments.

Given that many alternative strategies depend on exploiting short-lived arbitrage opportunities, as well as on new techniques and markets, grouping alternatives managers or strategies according to indexes and style boxes doesn’t make sense.

But for advisers, the ability to classify alternative strategies is critical. It provides a framework for evaluating performance history and helps them choose among the ever-growing number of liquid alternative strategies.

For instance, they can create peer groupings of like alternative-investment portfolios based on the sources of risk and underlying investments used.

In addition, strategies can be broken down by investment goal:

Enhanced equity: Increasing the performance and potential of a portfolio.

Hedged equity: Limiting equity exposure while staying invested in stocks.

Market-neutral equity: Capitalizing on a nontrending equities market by singling out stock-picking ability and targeting zero-equity beta.

Negative equity or bear market: Taking advantage of declining markets.

Strategic income: Tactically positioning bond exposure to take advantage of high emerging-markets yields.

Multi-strategy: Diversifying across different alternative strategies to provide broad exposure or shift allocation to capture opportunities.

Managed futures: Tapping into an additional asset class to access unique beta and potential alpha.

Research that is specifically targeted to liquid alternative investments provides a greater understanding of associated risks and allows advisers to demonstrate authoritative knowledge about each strategy.

Brandon Thomas (brandon.thomas @investpmc.com) is the co-founder, managing director and chief investment officer of Envestnet PMC, Envestnet’s portfolio management consultants.