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Liquid Alternatives: Invest Without Compromise

The Pandemic brought unparalleled volatility to financial markets in 2020. A recovery followed a sharp drop in the equity markets that was unprecedented in its speed. A similar outcome occurred in the credit markets with spreads returning to pre-pandemic levels due to the Federal Reserve's quick action. Commodities dropped also as future demand appeared weakened by the Pandemic. Thus, investors are increasingly sensitive to higher volatility and the prospect of low returns on their fixed income portfolios. The natural response is to seek alternative asset classes that mitigate portfolio risk while achieving a more consistent return stream.

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The challenge for investors is that non-traditional asset classes (e.g., hedge funds and private equity) that provide diversification are notoriously illiquid. This trait may heighten an investor’s risk when they require liquidity. Thus, access to the alternative risk premia is only valuable to an investor when it enables accessing their investments in turmoil times. When combined with returns that did not exceed the traditional asset classes over the last ten years, the case for higher fees and lower liquidity is not compelling.[1]

Liquid alternatives remove the liquidity constraint by matching the factor profiles of alternative strategies with liquid markets investments. Further, they provide an investment vehicle that reduces fees, delivers hedge fund-like returns, and helps manages total portfolio risk in a traditional portfolio. These benefits offer investors more choices to achieve their specific portfolio objectives. Liquid alternatives invest without compromise.

The Benefits of Fungibility and Accessibility

The value of liquidity emanates from its fungibility. Since the returns of assets are time-varying, liquidity offers the ability to switch into another investment offering a better relative opportunity. These relative value investments may arrive when illiquidity occurs because of a credit crisis, the popping of an equity bubble, or another market event. Liquidity permits an investor to exploit market events dynamically.

Fungibility enables tactical decisions.

The liquidity challenge is the trade-off between ready access to cash and expected return, particularly in a low yield environment. The promise of high returns in alternative asset comes at the cost of reduced liquidity. Hedge funds usually offer quarterly liquidity with advanced notice while private equity can lock up funds for five years or longer. The recent return performance of alternative asset classes places this trade-off in doubt.

The investor’s options for accessing hedge-fund return profiles are numerous. Research into the drivers of returns in alternative asset classes shows that liquid investments can replicate most of the traditionally illiquid asset classes' return and risk characteristics (i.e., hedge funds or alternative return strategies). While this outcome seems counterintuitive on the surface, there is a readily deductible explanation.

While some hedge fund strategies enter esoteric markets outside of the liquid markets (e.g., longevity insurance and catastrophe bonds), most participate in the traditional liquid markets: equities and bonds. Since markets match buyers and sellers, every strategy is a zero-sum game with winners and losers canceling each other. An individual hedge fund manager's focused approach may provide idiosyncratic risk. In contrast, a fully diversified portfolio of strategies, like an index of hedge funds, only has the non-diversifiable or systemic risks remaining (i.e., equities). Thus, the replication of a hedge fund index is possible if you can identify the relevant exposures.

Hedge funds are strategies, not assets.

Identifying the principal ingredients for a diversified hedge fund index is relatively straightforward. While how they implement any strategy is diverse, the focus of any strategy is not. Academic research identifies many inefficiencies in the financial markets that possess the potential of earning differentiated alpha. For example, the research identified the dominance of value (i.e., high book value) and size (i.e., low capitalization) in equity investing. The proliferation of exchange-traded funds (ETF) provides a means to access these factors cheaply and efficiently. Identification of exposures is an exercise is knowing the research.

Critical to understanding a hedge fund is that they are strategies, not assets. The distinction is vital to replication. A strategy is dynamic and changes positions over time. Conversely, a traditional fund manager is more static and may hold an investment position for years (i.e., value investor). In the former, exposures change over time with time-varying risk premia while constant in the latter. Thus, the crucial ingredient of liquid alternatives is to vary the market exposures over time.

The mantra of buy-and-hold is as old as investing. The difficulty of timing the market is canon. Yet, in a diversified portfolio, the only way to beat the market is timing. Widely considered the greatest investor of all time, Warren Buffet invests with two dictums. Only buy good companies (or conversely don’t purchase bad companies) and buy at a fair price. The first is a tool to manage risk while the second a comment on when to buy. The research affirms these attributes: risk premiums vary through time. Thus, the investor’s challenge is forecasting time-varying risk premia, a notoriously tricky proposition that humbles many investors.

The challenge of return forecasting is complicated and broad in scale. The diversity of strategies is as numerous as the number of hedge funds. Overcoming the obstacle occurs by following the insights from academic research. A diversified portfolio of strategies is effectively the consensus view of the market participants (i.e., hedge funds). Extracting the exposures is possible through an analysis of the benchmark returns. Time-varying risk premia require daily measurement. Implementation requires liquid and inexpensive vehicles. Thus, the potential exists for a return and risk profile resembling a hedge fund index. A considered implementation is critical. The benefit is clear: efficiency and liquidity without the trade-off.

Liquid alternatives access hedge fund-like return profiles.

The argument is compelling. Evidence even more so. Future posts will review index construction and how liquid alternatives are a viable solution for investors. The examination shows the impact of liquid alternatives on standard portfolio allocations. Of paramount importance to the investor is considering the trade-offs and probable decision points, which continues the discussion. While not necessary for every portfolio, the analysis conveys the potential benefits and costs of liquid alternatives in the portfolio to investors who demand more from their investments. Liquid alternatives provide accessibility and fungibility through their liquidity.

Invest Without Compromise

[1] For the 10-year period ending June 30th, 2020, the total return was: 13.8% for the iShares US Total Market ETF (ITOT), 3.7% for the iShares US Aggregate Bond Index (AGG), and 1.2% for the iShares 1-3-year US treasury Bond ETF (SHY). In comparison, the return was 2.1% or the HFR Investible Liquid Alternative Universe Index and 3.3% for the CS Liquid Alternative Beta Index. CRM calculations.


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