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Enhancing Diversity: Liquid Alternatives in the Portfolio

The strategic rationale for an asset class is whether it improves portfolio efficiency (i.e., the ratio of return to risk). The transient nature of expected returns and the measurable benefits of diversification implies that the risk component is more amenable to management. This does not suggest the irrelevance of the new asset class returns. The addition of an asset class to the portfolio must achieve either a similar expected return at lower risk or a higher return at a similar level of risk. For the former objective, adding Treasury Bills to the portfolio reduces portfolio risk and increases efficiency while possibly sacrificing the portfolio’s expected return target. In the latter objective, adding a higher return asset that adds disproportionately more risk can move the portfolio off the efficient frontier. Irrespective of the objective, the addition of an asset class must improve portfolio efficiency.

Photo: Artiom Vallat on Unsplash

We take stock of our inventory before we go to the store to buy groceries. Portfolio management is no different. The starting point for augmenting a portfolio with a new asset is the current risk factor exposure. A traditional portfolio is dominated by equity exposure with interest rate risk providing minor diversification (exhibit 1). Thus, the investor’s goal is to find an allocation that provides less equity exposure through diversification into the other factors.

Exhibit 1. Traditional Portfolio Risk Factor Exposure

Source: Capital Risk calculations. The traditional portfolio is 60% equity, 40% bonds with monthly rebalancing. Underlying investments are in ETFs. The period is January 2008 to June 2020. The performance is hypothetical and does not reflect an actual investment.

A traditional portfolio is dominated by equity risk.

Knowing the store inventory in advance is crucial to whether you will go there. Two of the more widely available hedge fund indices are from Credit Suisse with their Liquid Alternatives Beta Index (CSLAB) and Hedge Fund Research Liquid Alternatives Universe (HRLAU). While these universes differ in constituents and weighting schemes, together, they provide broad coverage of the investable universe. Critically, they are investable indices, which makes the comparison robust. Thus, these are the firsts store to visit for the enterprising investor looking for hedge fund-like returns and investability.