Bond yields have been falling for decades. As a result, c20% of bonds outstanding today are negative yielding, which poses two major challenges for investors. First, negative-yielding bonds result in a guaranteed loss for “buy-and-hold” investors, which – consequently – does not compensate for the risk of rising yields, at the very least, which could result in significant short-term losses. Second, the traditional hedging effect of bonds in equity market corrections is limited.
The synchronisation (correlation) between equities and bonds has increased and the limited scope for further falling yields in the event of a crisis limits the potential price gain for bonds. Therefore, especially in defensive and – by implication – more bond-heavy strategies, it seems reasonable to consider alternative investments to at least partially replicate or complement the traditional characteristics of bonds. In addition to commodities and illiquid investments, liquid alternatives are regularly mentioned for this purpose. What does this involve? Which strategies should be distinguished and what challenges do investors face when pursuing this path? We shed light on sensible approaches and report on our experiences.
The hedging and diversification effect of bonds decreases
In the past, multi-asset strategies that invest predominantly in equities and bonds regularly benefited from the consistently rising prices of safe government bonds when equity prices fell. However, Figure 2 shows that government bonds – which are considered “safe havens” – have recently no longer been able to live up to this role: While US government bonds still generated a return of over 30% during the financial crisis, they gained only 5% in the COVID-19 crash in 20201 and did not come close to offsetting the equity market losses of over 40% in some cases.
The fact that these bonds did not offset the equity market losses is mainly due to the lower interest rate level and the resulting lower buffer effect of the interest coupons, as well as the reduced scope for further interest rate declines from the current level. In the future, it is to be expected that this correlation between equities and bonds will continue in this vain.
Government bonds will have a hard time significantly alleviating losses on the stock market. In an environment characterised by a normalisation of central bank policy and a return to a higher level of inflation, government bonds and equities are likely to behave in parallel2 .
The increasing synchronisation of corporate bonds with equities, shown in Figure 3, also underscores the fact that both asset classes are suffering losses at the same time and that familiar diversification benefits from the past are only present to a limited extent.
Multi-asset strategies with higher bond ratios are particularly affected by the lack of a hedging effect. Consequently, there is a need for components that act as a stabiliser when the equity markets become more turbulent or rising interest rates lead to price losses on bonds.
Alternative sources of return are gaining importance
Strategies that enable a more independent development of returns in such an environment can be found in the broad spectrum of alternative asset classes. These can generally be divided into liquid and illiquid investments.
The risk and return drivers of both illiquid and liquid alternative investment strategies differ – at least in part – from those of traditional asset classes, which is why selected alternative investments are increasingly being used for diversification purposes. Examples of illiquid investments are private equity, private debt, hedge funds, collectibles (eg art, vintage cars, etc), real estate and infrastructure. Due to the complexity of valuation, these investments are usually only rarely priced, which is why they are not suitable for use in liquid investment strategies – they lack liquidity.
Pension funds that are not dependent on daily price fixing due to a long-investment horizon take advantage of the additional illiquidity premium and have accordingly increased their share at the expense of fixed-income segments – from 7% to over 26% in recent years.3 The area of more liquid investments in the alternative space mainly includes commodities and liquid alternatives. From an investor’s perspective, commodities fall into two categories: hedging investments, such as precious metals (eg gold), and investments with cyclical characteristics, such as industrial metals. As with the aforementioned illiquid strategies, liquid alternatives have different risk/return profiles and are suitable as investment alternatives or for portfolio diversification.
Liquid alternatives as an investment alternative?
Compared to traditional investment strategies, liquid alternatives generally make use of a larger toolbox of investment instruments and trading strategies, which enables an investor to profit from both rising and falling prices in various asset classes. In addition, leverage can be used to generate returns that diverge from traditional asset classes. Since the 1950s, such strategy building blocks have been implemented for large professional investors in the form of hedge funds in the US.
The main distinguishing feature between liquid alternatives and hedge funds is that the former – as a result of the regulated fund framework Undertakings for the Collective Investment in Transferable Securities (UCITS) – is much more strictly regulated to protect investors, thereby increasing the degree of transparency. Due to explicit position limits, it is not possible – for instance – to invest more than 10% of the fund volume in one position or to make investments in unlisted or unregulated investments. In contrast to hedge funds with monthly or quarterly liquidity – as well as substantial notice periods – liquid alternatives are largely tradable on a day-to-day basis, are usually less expensive and are not restricted to certain groups of investors.
Therefore, for investors who are denied access to hedge funds, they represent a useful alternative and are also suitable as a targeted supplement to traditional asset classes.
Broad universe of liquid alternatives strategies
In our view, investors should approach liquid alternatives from two different perspectives.
One perspective focuses on their use in a multi-asset context and distinguishes hedging from diversifying strategies. The former offer negative correlations to risky assets in times of stress and, as is traditionally the case with government bonds, aim to generate positive returns in times of crisis. The latter aim to improve the risk/return profile of traditional investments with the lowest possible correlation.