Liquid Alternatives: Clarifying Some of the Recent Press

We’ve seen some bad press lately about liquid alternatives saying that in general these new funds have not proven themselves. It’s no coincidence that this comes at a time when the equity markets are at all-time highs after a 5 year bull run. This bad press is unwarranted.

Many of these articles fail to point out exactly why alternatives are a necessary part of one’s portfolio. They are there as a diversifier to the rest of your portfolio; the zig to the zag. This diversification comes in quite handy when equity returns decline, volatility increases, and interest rates rise. All of which could happen sooner rather than later.

It wouldn’t make any sense if alternatives were up say 20% in a year stocks were up 20%. If so, those two asset classes are totally correlated. Alternatives best trait is being non-correlated to other asset classes, be it stocks and/or bonds. Frankly, expectations of alternatives are probably too high for most people. Our expectations for alternatives (as a group) would be around 6-8% per annum. But more importantly, our expectations for alternatives is that they won’t be down dollar for dollar when equities have a 10% or worse correction.

And that’s the real beauty. By using alternatives and avoiding a blow-up like many hard-core equity investors did in 2008, you don’t have a huge hole to dig yourself out of.

Investors should know that alternatives come in two categories:

  1. Alternative strategies – that utilize traditional asset classes (stocks and bonds) in non-traditional ways. Examples: Long/Short Equity, Long/Short Fixed, Market Neutral
  2. Alternative assets – non-traditional asset classes (anything that’s not a stock or bond). Examples: Real Estate, Infrastructure, Commodities

*Some alternative funds combine both strategies and assets. Examples: Managed Futures, Multi-Strategy, Fund of Funds.

Alternatives are typically used for four major reasons:

  1. Reduce Volatility
  2. Generate Income
  3. Increase returns
  4. Address A Specific Risk

Most alternatives may only align with one of the four objectives above. Very rarely will an alternative be able to do all of that. For example, infrastructure is really just a “generate income” play. Whereas Market Neutral isn’t necessarily increasing returns or generating income but there to reduce volatility and limit max drawdown. The table below shows how different these alts can be.

Liquid alts

That being said, you need to know what you own to invest in this area. As a portfolio manager, DWM seeks to understand the risk/return profile, market exposure, correlation to traditional asset classes and the manager skill and experience before we make an addition to our Liquid Alternatives Model. We also identify how one fund correlates (or hopefully doesn’t correlate) with the other funds within the model. We think our model blends the above objectives in a optimized way to benefit our clients’ portfolios. We’ve been working with “liquid alts” for a decade now and they have proven to be quite beneficial for us and our clients.

In conclusion, the bad press we see every once in a while on liquid alts is not warranted and typically comes from the misunderstanding of what can be a complicated area. We hope this article has provided some education. For further information on alternatives, don’t hesitate to contact us.