As regular readers know, a topic that has concerned investors for some time is how to achieve genuine diversification, and find uncorrelated assets. The author of this piece examines the case for "liquid alternatives".

The following guest article is by David Feldman, president and co-chief investment officer of Palladiem, an asset management firm headquartered in Malvern, PA. (There is more detail about Feldman below this article.) He writes the market in what are called “liquid alternatives” and their use in a diversified portfolio. As ever, the editors of this news service don’t necessarily endorse all views of guest contributors and invite readers to respond; we are, however, delighted to receive contributions from industry figures and for contributing to debate. Email the editor at tom.burroughes@wealthbriefing.com

A recent Cerulli Associates report found that a third of all households have zero familiarity with liquid alternatives.(Footnote 1) Though liquid alternatives have grown in number and market share since the financial crisis, investors and advisers still lack clarity and understanding around the essential role that liquid alternatives should play in a diversified portfolio. And in today’s market conditions, true portfolio diversification, which in our view requires liquid alternatives, is more important than ever.

Stocks have recently set all‐time high records with the “Trump bump,” but the underlying conditions of lackluster income, productivity, economic, and corporate earnings growth, coupled with the overvaluation of both stocks and bonds have troubling implications. Lower future returns, higher expected volatility, and higher correlation make the pursuit of investment objectives challenging. External market pressures in the form of record public and private debt, the uncharted waters of central bank policy globally, changing demographics, costly entitlement programs, and the rise of populist political sentiment add an additional layer of complexity.

Given this backdrop, investors’ hard won gains over the past few years could be in serious jeopardy, not just from the ordinary ups and downs of investing, but from a simultaneous reset of stock and bond prices. Advisors must adopt a new approach to portfolio construction that moves beyond a simple diversified, market capitalization weighted stock and bond portfolio to include other potential sources of return and diversification. We believe liquid alternatives are a critical part of such a portfolio and ‘forecasts predict that liquid alternatives will represent 14 per cent of total industry assets by 2023.’ (Footnote 2.)

Liquid alternative strategies offer retail investors the opportunity to tap other sources of return that 1) are not typically found in the traditional asset classes, and 2) have tended to be less correlated to the stock market, thus creating a more diversified overall portfolio. The strategies encompass a wide variety of investment types that provide exposure to real or other non-traditional financial assets, yet are still accessible via mutual funds or exchange traded funds. These investment exposures may include real estate, commodities, precious metals, currencies, and private credit/equity. 

But in order for advisers to implement liquid alternative strategies in client portfolios, they must first educate their clients on liquid alternatives, which means answering three key questions.

What are the expected benefits? 
Liquid alternatives can redeemed daily, unlike traditional alternatives which are typically restricted to monthly or quarterly liquidity. They have fewer barriers to investment, including lower minimum investments than typical alternative strategies like hedge funds. They typically do not require investor accreditation or K1 tax reporting. In addition, the increased transparency of liquid alternatives versus their traditional alternative brethren is another key feature that we believe is a necessity for proper risk management.

A reasonably priced, effectively executed liquid alternative allocation can potentially: 

•    derive higher long‐term returns for your clients in a return scarce environment
•    protect against major drawdowns like those suffered by investors in the tech wreck and financial crisis
•    help smooth the volatility experienced along the way
•    help with portfolio compounding by reducing drawdowns
•    reduce investment costs substantially relative to less liquid, traditional alternatives 
•    provide portfolio diversification without the explicit use of leverage
•    keep clients focused on what really matters – their personal long term goals

Even in primarily fixed income portfolios, alternatives can play a role, from generating yield with limited duration exposure to diversifying interest rate cycle and credit exposures.

What are the tradeoffs?
An alternative investment allocation will likely lag equity segments of a portfolio during strong upward periods in the stock market. The purpose of the allocation is to reduce total portfolio volatility and mitigate the negative impact of a major equity market drawdown. Alternative investments can be more complicated to research and understand, requiring additional time and resources on behalf of the adviser, making them more expensive to implement.

Where is the alternative allocation funded from?
The source of the new allocation depends on a variety of factors, including the required return, investment objective, time frame or investment horizon, and risk tolerance of the investor. Most portfolios are dominated by equity risk; even the classic 60/40 portfolio derives more than 90% of its volatility from the equity side. Since the alternative allocation is intended to reduce risk, funding primarily from the equity bucket may make sense. This must be balanced with an expected reduction in return contribution and must be evaluated in the investor’s required return framework.
Allocation to liquid alternative strategies should not be based solely on historical risk and return measures, nor be naively static, but should involve a dynamic process that incorporates a view on current valuations, the current and prospective market backdrop, and expected behavior of the strategies under severe market stress conditions.

Evaluating and incorporating alternative investments requires a more extensive level of analysis than traditional strategies and the application of a strict due diligence process. But, when appropriately executed, cost-effective and transparent liquid alternative investment strategies provide the opportunity for the risk mitigation and total portfolio diversification necessary to help investors, and their advisers, reach their financial goals.

Footnotes:

1, Cerulli Associates March 2017, "Investor Understanding Of Liquid Alternatives Remains Low."

2, BNY Mellon - "Split Decisions - Institutional Investment In Alternative Investments".

About the author

David Feldman serves as President and Co-CIO of Palladiem. He has a diverse background, with experience in all aspects of investment management. He has worked with a wide range of defined benefit and defined contribution plans, institutional investment consultants, mutual funds, collective investment funds and annuities.