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.

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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.

An asset class must improve portfolio efficiency.

A review of the risk factors provides a material insight into their applicability. The major risk factor, equity, is much less material to the hedge fund indices (exhibit 2). Further, the specific risk accounts for 50 to 70% of the risk.[1] This is a beneficial ingredient for improving portfolio efficiency for the traditional portfolio. While the other factors play a minimal role, they are larger in magnitude than the traditional portfolio, which aids in diversification at the margin. The risk analysis suggests that liquid alternatives provide beneficial diversification.

Exhibit 2. Liquid Alternatives Indices Risk Factor Exposure

Source: Capital Risk calculations. Data is the Credit Suisse Liquid Alternatives Beta Index and the Hedge Fund Research Investable Liquid Alternatives Universe. The period is January 2008 to June 2020. The performance is hypothetical and does not reflect an actual investment.

The risk factors are different in liquid alternatives.

The mix of ingredients is vital to a good recipe. Portfolio construction is similar. The addition of a new asset requires the removal of another (although leverage is possible, it’s not considered here). While any of the assets are possible, the risk factor exposure provides guidance. The exposure to non-US equities would suggest that it might be fungible. Further, the low exposure to interest rates and high specific risk suggests that it may act as a replacement for shorter-term Treasury Bills and Bonds in a portfolio.[1] The goal of the addition is enhanced efficiency.

The new portfolio replaces 10% of the Developed ex-US equities with the Credit Suisse Liquid Alternatives Beta Index and 10% of the US short-term Treasury Bonds with HFR Investible Liquid Alternatives Universe Index. The payoff is compelling. The traditional portfolio is improved for each portfolio measure (exhibit 3). The return is parallel, the risk and drawdown are lower, while the ratio is higher than the three components. Further, there is a marked reduction in risk and its contribution from non-US equity reduced. The benefits are palpable.

Exhibit 3. Portfolio Risk Factor Exposure with Liquid Alternatives

Source: Capital Risk calculations. The benchmark portfolio is 60% equity, 40% bonds with monthly rebalancing. Underlying asset class investments are in ETFs. The portfolio replaces 10% of EAFE Equity and 10% of short-term US Treasury with 10% of Credit Suisse Liquid Alternative Beta Index (LAB) and 10% Hedge Fund Research Investable Liquid Alternative Universe Index (LAU). The period is January 2008 to June 2020. The performance is hypothetical and does not reflect an actual investment.

Adding Liquid Alternatives improves every portfolio measure.

The case for liquid alternatives in the portfolio is compelling. While the past is not prelude and the future may be different, their inclusion improved portfolio efficiency in the period evaluated. The demonstrated benefits to the portfolio include:

Enhanced Efficiency - Liquid alternatives improve a portfolio risk-adjusted return with no sacrifice to return. Further, the result is a portfolio that is higher in efficiency than its three components. This outcome displays the value of diversification.

Capital Preservation - Liquid alternatives reduced total portfolio risk and mitigated the maximum drawdown. In the last two decades, equity drawdown approached 50% twice, and the recent Pandemic crash saw equities fall over 30%. In the two most recent equity pullbacks, the portfolio with liquid alternatives endured less of a drawdown.

Risk Factor Exposure – In an environment where near-zero interest rates could persist for years, the value of reduced exposure to interest rates is valuable in two ways. First, the risk of lower bond returns with higher interest rates is reduced. Second, the ability to earn more than the near-zero return on short-term Treasury Bill is beneficial. Further, the reduction in equity market exposure helps mitigate the next equity bear market.

While the portfolio benefits are apparent, there are more practical benefits for the investor. Transitioning into a hedge fund allocation is a long process because of the required manager due diligence and the lock-up periods that provide access monthly, quarterly, or longer. Further, the inability to exit the strategy on-demand results in the investor bearing reduced liquidity in their portfolio. Liquid alternatives address these concerns because they are more practical.

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Invest Without Compromise

[1] For FTSE Aggregate US Bond Index about two-thirds of the index is in Treasuries or about 25% of a traditional 60% equity and 40% bond portfolio. [1] This level of specific risk is material. The challenge is that it results from the fees, which reduce the level of return. This outcome is analogous to negative alpha).