Liquid alternatives explained

The term “Liquid Alternatives” is used by different people in different ways, and covers a range of strategic approaches and portfolio characteristics. his short article provides an overview.

Strong demand for Hedge Funds

Liquid Alternatives have been attracting ever increasing interest in recent years, both among investors and in the capital markets. The term refers to a broad segment, which makes clear definitions and careful use of terminology important.

Lower return prospects in traditional markets over recent years have turned latent interest in Alternative Investments into a real need. When it is neither desirable nor possible to invest in illiquid investment segments such as Private Equity, Infrastructure and Direct Lending, investors seek alternative options in liquid capital markets. This typically involves strategies that most frequently take the form of Hedge Funds. Even in the current market environment, such funds can deliver a return of 5–10% with manageable risks. Global demand is correspondingly high in this segment: assets under Hedge Fund management have long surpassed their pre-financial crisis peaks.

Critical public perceptions

In continental Europe, this access route is no longer a real option for the vast majority of investors due to negative public perceptions combined with corresponding regulatory and tax obstacles. Consequently, there is steady demand for alternatives that display the desired properties in relation to regulation, liquidity and fees. These products are increasingly now referred to collectively as “Liquid Alternatives”.

Alpha and beta as aids to understanding

The range of products in this segment extends from “normal” Hedge Funds in a UCITS wrapper through to less controversial multi-asset options such as risk parity strategies. To make sense of the many different approaches, it is helpful to refer to the familiar concept of alpha and beta – in other words, the distinction between returns generated primarily through active management (“alpha”) and those captured as risk premia for taking on systematic risk (“beta”). A key aspect in the latter category is that systematic risk is not necessarily limited to traditional asset classes (as in most risk parity strategies, for example); less common risks, such as term premium, carry, momentum and volatility, are also captured, giving rise to the term “alternative beta”. All these strategies nevertheless have one thing in common: they use no benchmark and accordingly come under the general heading “absolute return”. As such, all the approaches discussed here are fundamentally different from strategies for index optimization (“smart beta”), even though similar tools are used in some cases to achieve a different goal.

Alpha strategies against over-regulation and for liquidity

When the focus with Liquid Alternatives is on alpha, key criteria are regulation and liquidity. The management fees are typically not very different despite the UCITS wrapper. This market segment has evolved considerably. Nowadays, investment strategies are increasingly pre-selected on the basis of regulatory frameworks. This has greatly boosted the likelihood of generating good results even in the tightly controlled UCITS environment. When selecting funds, it is nonetheless still important to ensure that the underlying strategies and securities can provide the promised liquidity in an emergency.

A reduced burden of fees with beta strategies

Addressing the question of fees requires a focus on beta strategies. In the case of investors who expect that their active managers will generate insufficient added value to cover their fees, this approach is by definition the number one choice. This option is also of interest to investors who would like to limit their fee burden or simply want to retain maximum flexibility thanks to a particularly high level of liquidity. This typically involves quantitative approaches, which can be divided into three categories.

The term “alternative beta strategies” refers to cases where risk premia are captured outside traditional asset classes. The underlying systematic risks can vary widely, from factor risk in the equity market and term premium in the bond market through to momentum, carry, volatility premia and acquisition risk premia. Although this variety may appear daunting at first, it is the basis for one of the key attributes that make Alternative Investments so attractive: diversification of the two dominant risk factors – equity market risk and duration. In addition, reducing portfolio management to market access and systematic risk management not only enables high liquidity, it also means that fees are comparatively low.

With the second category of beta strategies, the strategy is limited to traditional asset classes, with a focus on risk management and risk limitation. In the simplest case, this means a risk parity approach, although increasingly with extensions aimed at better control of drawdowns. This category often appears the most familiar, because it uses mainstream asset classes. However, this comes at the expense of untapped potential for improving returns and diversification.

The third category of beta strategies seeks to mimic the Hedge Fund industry via factor replication of past Hedge Fund returns. These Hedge Fund replicators are offered in a range of variants but enjoy relatively low acceptance due to conceptual issues, especially relating to their backward-looking approach, direct association with the world of Hedge Funds and, in some cases, not very impressive results.

Whether alpha or beta, the focus is on performance

The common feature of all Liquid Alternatives is that they offer a simple way to access alternative investment strategies. There is an increasing need for such strategies, given very low interest rates combined with credit and equity markets that have been performing well for year.