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Does your liquid alternative fund live up to its name?

03-10-2016 | Interview | Alexander de Roode, Thijs Markwat

Liquid alternatives are receiving more attention from investors in the current landscape of low yields, lower expected returns and fewer diversification opportunities. But do all liquid alternative funds deserve the label ‘liquid alternative’? Many do not, and it is time to separate the wheat from the chaff, say quantitative researchers Alexander de Roode and Thijs Markwat.

Speed read
  • True liquid alternatives deliver diversification by exposure to alternative risk premia
  • The impact of liquid alternatives styles on the investor’s portfolio can be quite different
  • Liquid alternatives can create more balanced investment portfolios

Liquid alternatives are designed to answer the need for alternative sources of return and diversification. This new type of investment vehicles can broadly be described as hedge funds in a mutual fund framework. Liquid alternatives are gaining more attention from investors as a replacement for hedge funds, but remain relatively unknown. Given the current market environment, investors are intensifying their search for alternatives that can deliver return and true diversification in their portfolios.

Therefore, interest in the alternative universe is increasing, leading to questions about the potential benefit of such allocations. In particular, investors are questioning how liquid alternatives compare to the broad alternative investment universe. De Roode and Markwat searched for answers and wrote a white paper, ‘Defining liquid alternatives’. They evaluate liquid alternatives, define their key characteristics, and present criteria for investors to evaluate them in portfolios. Here, there are answers to some of the questions surrounding this concept.

Your white paper suggests that some fund managers have gone too far in their use of the label ‘liquid alternatives’. So do these funds not live up to their name?
Markwat: “We see many funds that label themselves as liquid alternatives. Some of them are somewhat misleading. They do not offer exposure to true alternative risk premia but instead offer traditional risk premia. This has created tension between those offering true liquid alternatives strategies and those funds who want to ride the wave but do not necessarily diversify investor’s portfolios.”

Is that why you begin with a definition of what liquid alternatives actually are?
De Roode: “Yes. In the alternative investment universe, we distinguish between alternative strategies and alternative asset classes. In our definition, alternative strategies deliver diversification to a portfolio through exposure to alternative risk premia. Alternative asset classes, on the other hand, solely give an investor static exposure to non-traditional assets.”

“If an alternative investment fund loads substantially on traditional risk premia, then this strategy does not fit the definition of ‘alternative’. True liquid alternatives deliver diversification by exposure to alternative risk premia, whereas others show larger correlations with traditional risk premia and do not diversify.”

“Most funds in these alternative strategies category apply very broad investment strategies such as global macro, equity market neutral or managed futures. Conversely, alternative strategies can also consist of those that are only applied to the traditional asset classes of equities and bonds. In that case, the ‘alternative’ character solely comes from the strategy, and not from the underlying investments in alternative asset classes. An alternative strategy should capture another source of return than traditional market exposures.

‘Transparency is a key characteristic of liquid alternatives’

How can investors separate the chaff from the wheat?
De Roode
: “We identify three important criteria for liquid alternatives. The underlying strategies must give exposure to alternative risk premia; they should be liquid, and they should be transparent. Exposure to alternative risk premia can only be obtained through investment strategies. To evaluate whether a liquid alternative can be considered as such, the underlying investment strategy needs to be analyzed.”

“Transparency is an important characteristic. We believe transparency is a key feature in the evaluation of whether funds can be defined as liquid alternatives. Transparency allows investors to analyze whether the exposures of the investment strategies fit into their portfolio. Transparency also helps investors to determine the optimal allocation in their portfolio.”

“A third characteristic of ‘liquid alternative’ is of course liquidity. Alternative strategies can provide access to illiquid assets such as direct real estate, infrastructure and private equity. These strategies cannot be implemented by any investor due to their strong constraints. As such we do not regard such investments liquid alternatives.”

three-criteria-of-liquid-alternatives.jpg

What do you advise investors who are considering investing in liquid alternatives?
Markwat: “To begin with, investors need to analyze their portfolio. This analysis can reveal that they have a limited exposure to alternative risk premia, whereas a more diversified portfolio requires a broader scope than only targeting traditional risk premia. Exposure to alternative risk premia can be found in liquid or illiquid alternative investments.”

“Investors have to decide if they can tolerate illiquid investments in their portfolio, or if they are dependent on liquid alternatives. Factors such risk appetite, liabilities, investment beliefs and investment goals play an important role in this decision. Due to internal constraints, not every investor can have an exposure to illiquid investments. As an alternative to these investments, investors can turn to liquid alternatives.

“The return characteristics between alternative liquid strategies, and even within one category of strategies, can be quite large. With the large dispersion in the liquid alternative universe, the impact on the investor’s portfolio can be quite different. Therefore, manager selection is key.”

And last but not least, we ask investors: do you fully understand the alternative strategy, and can you fully support the investment in good and bad times? You need to do your homework and seek advice when necessary, as liquid alternatives consist of very different strategies, and are often hard to understand. If you do not fully understand the strategy, do not invest in it.”

What is your verdict on liquid alternatives?
De Roode: “Liquid alternatives can give investors exposure to alternative investment strategies in an efficient way. They provide a relatively new opportunity for most investors to engage in hedge fund-style investment strategies. These exposures can create more balanced portfolios. But the actual selection of alternative strategies depends on the investor’s characteristics and preferences. And the alternative strategy must meet the criteria for being truly alternative.”

Dynamic Strategic Asset Allocation and Stress Test tools
The allocation to liquid alternatives requires thorough analysis of the investor’s portfolio. Robeco’s Dynamic Strategic Asset Allocation (DSAA) and Stress Test (ST) tools are powerful instruments with which to evaluate the impact of adding liquid alternative strategies to an investment portfolio. They can guide an investor to the optimal level of liquid alternatives allocation. Read also ‘The dynamic duo: how to really understand the nature of your investment portfolio’.
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