Liquid alternatives is a complex and hard-to-define asset class. Perhaps the most-prevailing consensus is that the asset class constitutes a wide range of “hedge fund strategies”. We define it as non-traditional return drivers embedded in traditional asset classes that can be imperfectly extracted through various means (such as buying and selling assets simultaneously).
More often than not, the asset class is labelled as market neutral with properties that are uncorrelated with traditional asset classes. We believe that such labels are simply incorrect and that investors adamantly pursuing absolute market neutrality are likely to fail. There certainly are unique value drivers in liquid alternatives, but if attempting to hedge away the correlated factors, investors will often end up achieving little more than overwhelming the embedded alpha. The nonlinearity and time-variation in risk and co-movement between liquid alternatives and traditional asset classes makes it almost impossible to perfectly isolate and precisely capture the alpha without accepting some of the beta. Indeed, many money managers have experienced dire results in recent years that contribute to an overly aggressive pursuit of market neutrality.
Nonetheless, liquid alternatives have a very important role to play in modern multi-asset portfolios. In DBAM, we have accepted that nonzero correlation is unavoidable and treat liquid alternatives as an addition to the mix of asset classes, and use it to construct better portfolios.
Liquid alternatives and subgroups
Perhaps more than other asset classes, liquid alternatives contain sub-classes. There are sub-labels such as equity long short, carry, value, momentum and trend following, etc. Our approach is to define two categories based on directionality (Carry or defensive) with two sub-types measured by the magnitude or linearity of the directionality.
One benefit is complete transparency in terms of the properties of each sub-class. Another benefit is that we can tailor the implementation of the exposures. Particularly, Defensive strategies need to be managed actively and with a degree of discretion and must be specified for each portfolio. In contrast, beta replacement strategies can be managed more quantitatively and as “one-size-fits all”.
Carry comprises beta replacement and overlay strategies. Beta replacement represents strategies with substantial correlation to the underlying asset while overlay represents strategies with partial or nonlinear correlation properties. Both have value drivers that offer return in excess of their betas (alpha), but it may be difficult to achieve without accepting some correlation. Overlays require significant PM activity, and the bulk of our exposure is through internal hedge fund franchise.
The Defensive basket falls outside of what is typically considered liquid alternatives, yet a similar framework is useful. We use directional tail hedging to mitigate the worst drawdowns, which allows us to hold more exposure to traditional assets, carry strategies, and ultimately generate higher returns. In addition, we have specified scenarios where our portfolios are particularly vulnerable and goal-based hedging strategies to offset the drawdowns. One example is stagflation where rate diversification is less likely to work in our all-weather inspired portfolios. Defensives should be tailor-made to the SAA, thus we have chosen to manage all strategies directly and internally.
*This article was originally published on the March edition of our RankiaPro Europe magazine, if you want to read more like this, you can download the full magazine here.