Integrating liquid alternative investments into portfolios
In an environment of historically low but potentially rising yields and increased volatility, multi-asset portfolios face numerous challenges, hence the need for uncorrelated liquid alternative investments should rise
Liquid Alternative Investments (liquid AI) refer to strategies that are available through liquid investment vehicles such as mutual funds or ETFs and provide daily or weekly liquidity. Historically these investment strategies showed relatively low sensitivity and correlation to stock and bond market movements, which make them effective portfolio diversifiers and could be of value for private and institutional clients.
For a long time, traditional AI have only been available to institutional investors, mainly in the form of unregulated hedge funds with high minimum subscriptions and long lock-up periods. Today, a lot of those strategies are made available to retail investors in liquid, Ucits-compliant investment vehicles such as ETFs or mutual funds. Private clients can choose from a variety of single or multi-strategy approaches. Furthermore, liquid AI strategies get a lot of attention because they overcome additional weaknesses of traditional hedge funds, as they offer products associated with lower costs and often more transparency.
Liquid AI portfolios
Defensive investors:
• Primary goal to achieve optimal diversification within the multi-asset portfolio and focus on correlation effects with traditional asset classes
• Multi-strategy approaches as core investment; potentially adding defensive satellite investments
• Liquid AI serves as a fixed income substitute with a large focus on drawdown risks, volatility and optimising income
Balanced investors:
• Investors are used to bearing greater volatility, thus liquid AI aims to be an effective diversifier and add alpha
• Multi-strategy approaches as a core investment and to a larger degree higher risk/return profile investments as satellites
• Allocation assists in substituting fixed income as well as equity risks with an uncorrelated character, though higher risk/return strategies might be used
Aggressive investors:
• Investors primarily target uncorrelated alternative returns
• More aggressive multi-strategy approaches can take a role as core investments, supplemented by more risky approaches
• Liquid AI should add to overall diversification but must be counted as equity substitutes
This trend could continue as retail investors become more sensitive to improving their overall portfolio diversification in order to avoid the kind of volatility they experienced during market turmoil in 2008 and 2011.
However, liquid AI offer both opportunities and challenges for investors. There is a potential risk of inexperience among retail investors which can be mitigated by working with an experienced wealth adviser who adds knowledge in evaluating, monitoring and selecting AI vehicles. The implementation of previous hedge fund strategies in a multi-manager framework is complex and investors should not underestimate the importance of building industrial expertise in this field and having the right partners. Investors can either build expertise in-house or delegate the selection to an external advisor. Quantitative and qualitative selection criteria should be considered in the selection process. Investors have several tools at their disposal which help to obtain industry experience in a simple way, however the key is to know how to use them, which strategies to select and a proper portfolio weighting.
Investors can use databases in order to generally screen the market. However, the liquid AI universe is very diverse and heterogeneous, so sometimes a simple database search and ranking might not lead to the expected results.
Additionally, one can find numerous providers of integrated platforms which make liquid AI strategies available and moreover take care of the day-to-day back office business such as reporting, compliance or accounting.
It is, nevertheless, important to conduct traditional due diligence, to understand the strategy, meet the manager and evaluate the historical data and operations.
The liquid AI universe is broad, with diverse risk-return profiles across the different types of strategies, hence investments need to be filtered according to clients’ needs. Investors who are more risk-averse and historically have lower allocations of stocks may be not willing to take on a high degree of volatility in their AI bucket.
More aggressive investors, used to higher volatility, might ask for more aggressive strategies with higher return potential but lower correlation. Depending on the allocation to alternatives and a client’s general risk/return profile, the liquid AI portfolio should include the investments summarised in the table.
Liquid AI can help stabilise portfolios by delivering differentiated returns. Through the use of other risk/return sources, compared to traditional equity and bond risk premia, they can improve returns, create additional return streams and dampen volatility by improving overall portfolio diversification. These vehicles provide more liquidity and transparency than former offshore hedge funds, but the selection of strategies will differ depending on a client’s risk/return profile. However, in total the benefits are attractive vis-à-vis the risks and liquid AI could be a solution in an environment of low yields and increasing volatility by providing uncorrelated returns.
Stefan Keitel, global chief investment officer/head portfolio management & advisory, Berenberg
Philip Kalthöfer, portfolio manager multi-asset & alternative investment, Berenberg
