The Potential of Liquid Alternative Strategies

“Liquid alternatives” is a term increasingly used in the financial field. Hugh Prendergast, Head of Strategic Product and Marketing at Pioneer Investments, looks at the reasons why such strategies may be a perfect fit for the current challenging market environment and explains how liquid alternatives can offer enhanced diversification, reduce directionality and increase the potential for truly uncorrelated alpha [1] .

Ultra-low interest rates, high volatility and the collapse of traditional market correlations – is this the new reality in the markets?

The times in which investors were able to ensure adequate portfolio diversification through 60/40 weightings of equities and bonds are definitely over. The experiences in 2008 and 2011, with market volatility exploding and normal correlations [2] across all asset classes collapsing, in conjunction with the low-interest-rate environment that has been prevailing for many years, are posing enormous challenges for many investors. And the most recent price slump in the markets has shown that these scenarios can repeat themselves. This means that it definitely makes sense to consider redrawing the investment map in investors’ portfolios. After all, many investors have “grown up” and are increasingly demanding product solutions that may prove to be robust in extreme situations too.

What suggestions would you give to investors?

Investors should consider new sources of return that can offer adequate diversification [3] – beyond the traditional directional asset allocation. At the same time, these strategies should also be able to offset potential drawdown risks and high market volatility with a view to generating “genuine alpha“ – i.e. excess return in relation to the general market trend.

What types of solutions do you have in mind?

Absolute-return strategies seeking to generate positive returns in different market environments can provide effective portfolio diversification, enhance risk-adjusted return potential and help act as shock absorbers during stress periods in the market. Traditionally, the correlation between such absolute-return strategies and the global equity and bond markets has been relatively low, as the underlying strategies basically focus on absolute rather than relative returns.

How do you define “liquid alternatives”?

In our definition, the term “alternative investments” covers a broad range of strategies that aim to target a source of return differentiated from traditional, long-only equity and bond market exposure. Examples of alternative approaches include long/short strategies, which, among other things, play individual currencies or stocks against each other. Simultaneous purchases and sales of positions can generate relative, market-independent returns, because the key determinant is the comparative price performance among the individual assets. And “liquid” refers to the ability to transact in transparent, regulated portfolios which usually offer daily liquidity. The latter, in particular, adds crucial value from investors’ perspective, too.

What features may “liquid alternatives“ offer client portfolios?

We believe that the big aspect of these strategies is that they may bring their strengths to bear when traditional asset allocation may no longer be effective due to unforeseen market turmoil. Liquid alternatives are typically not subject to any benchmark and are designed to generate market-independent returns – in a wide variety of different market phases. By building up add-on positions in liquid alternatives, investors can also gain access to forward-looking strategies outside the traditional asset classes of bonds and equities. And there is more: these strategies may enhance diversification und help reduce risk at the portfolio level. Last but not least, they seek to deliver a potential return component for the portfolio.

All investments are subject to risk, including the possible loss of principal. Liquid alternative strategies involve higher risks than traditional investments and may also engage in speculative investment techniques that can magnify the potential for investment loss or gain.

[1] Alpha:

The additional return above the expected return of the beta adjusted return of the market; a positive alpha suggests risk-adjusted value added by the money manager versus the index.

[2] Correlation:

The degree of association between two or more variables; in finance, it is the degree to which assets or asset class prices have moved in relation to one another. Correlation is expressed by a correlation coefficient that ranges from -1 (never move together) through 0 (absolutely independent) to 1 (always move in opposite directions).

[3] * Diversification does not ensure a profit or protect against a loss.