Liquid alternatives: What to consider when looking for the right manager?

To integrate the appropriate strategy into an existing portfolio, six steps are important in our view – which we describe in more detail in the following sections.
Tobias Schäfer

Portfoliomanager Multi Asset - ETF and Manager Selection

Berenberg

Christoph Netopil

Portfoliomanager Multi Asset

Berenberg

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This is the second part of the article about Liquid alternatives published last week. Once the strategies have been classified based on the two perspectives described, the question of implementation arises. To integrate the appropriate strategy into an existing portfolio, six steps are important in our view – which we describe in more detail in the following sections.

First, it is important to be aware of the particular challenges involved in the product selection of liquid alternatives; in the next step, two overarching implementation variants can be distinguished. Next, it is important to clarify the objective that the strategies should fulfil. Ideally, this objective should be quantifiable and should allow success to be assessed on an ongoing basis. The next step is the selection of managers and portfolio construction, followed by the embedding of the strategy into the existing multi-asset portfolio. Finally, specific features in the management of the strategies are briefly discussed.

1. Special challenges in product selection

In addition to the advantages mentioned, liquid alternatives raise questions that investors are not familiar with compared to when selecting equity and bond funds. Complexity: Since the strategies use leverage by means of derivatives and can bet on both rising and falling markets, the product construction is complex. In addition, the respective investment processes and risk management systems are very individual, which requires comprehensive examination and analysis before an investment is made.

Comparability and assessment: Liquid alternatives are difficult to compare with each other, as the liberties are much broader than in traditional investment approaches. The majority of strategies pursue the goal of achieving positive investment results in all market phases. Therefore, comparing returns or risk with equity indices, such as the S&P 500, does not help to assess performance. Accordingly, own models or comparison groups have to be built.

2. Different implementation variants

At first glance, the various strategy types in the realm of alternative strategies result in a wide range of possible combinations for the integration into a multi-asset approach. First, however, an overriding decision must be made. Should multi-strategy or multi-manager approaches be used, or is the individual composition of a portfolio from single strategies the aim? Investors in multi-strategy or multi-manager approaches benefit from professional expertise as a complete package is offered – from selection and weighting to monitoring, rebalancing and risk management.

This is accompanied by access to strategies that are in part not investable on an individual basis, as well as increasing negotiating power in terms of fees towards the providers of the selected sub-strategies as the investment volume increases. In the case of individual composition, on the other hand, the investor retains control over the selection of strategies and managers, as well as all further downstream steps in the investment process. This allows for a more individual adjustment to the investor’s own investment objectives and the given asset allocation, although it does require the corresponding expertise and a higher effort in the selection and ongoing management. In return, however, the degree of transparency can be increased and the cost burden can be reduced by eliminating the need for an intermediary.

3. Specification of the investment objective

Once this fundamental decision has been made, it is then necessary to decide on the objective of alternative investments in the overall portfolio context. If additional diversification at portfolio level is desired, multi-strategy and multi-manager approaches can improve the profile (see Figure 4). “Financing” from the equity and bond quota is conceivable here. If specific equity or bond profiles are to be optimised over and above the diversification of the overall portfolio, it makes more sense to use complete flexibility and control and to generate the desired return/risk profile yourself by putting together individual strategies. Three variants can be distinguished here.

  • In order to take account of the reduced hedging effect of government bonds, the use and combination of long volatility strategies and managed futures strategies is appropriate, depending on the desired risk/return profile. Both have a hedging effect, particularly in times of crisis. 
  • In the current low interest rate environment, four strategies are suitable for replicating the return profiles previously associated with bonds without being directly exposed to interest rate risk. In the defensive segment, marketneutral equity strategies and alternative bond strategies are particularly suitable. Event-driven strategies – which exploit arbitrage opportunities as neutrally as possible within the framework of capital market measures – have a similar profile, with a somewhat more offensive orientation. In principle, convertible arbitrage strategies also pursue a market-neutral collection of premiums, but only a few strategies are currently available on the market in the form of liquid alternatives. 
  • If the aim is to diversify the equity exposure in order to reduce volatility and minimise drawdowns, long/short equity strategies can be used. Compared to a complete direct investment in equities, the possibility of profiting from falling prices through short positions and the reduced market risk – especially in times of crisis – help to preserve capital.

Depending on which of the three objectives is in the foreground, the resulting allocations differ. If the focus is on hedging against equity market corrections, the portfolio’s risk/return profile improves even with a low allocation of hedging strategies. In order to take account of the lower interest rate level and the increased correlation between bonds and equities – particularly in defensive multi-asset mandates – a combination of hedging and diversifying strategies is sensible. Here, the allocations should be chosen specifically with a focus on the bond allocation to achieve an effect on the overall performance of the portfolio, but without significantly changing the originally intended risk profile of the portfolio. 

4. Manager choice / manager selection

Compared to traditional investment approaches, extensive flexibility and greater room for manoeuvre ensure that the investment ideas and their implementation are decisive for performance. The broad market trend plays a rather subordinate role. Accordingly, however, it is evident that only a few managers are able to convince across all market phases and generate sustainable excess returns (alpha). The dispersion between very good and bad managers within the UCITS fund universe (as shown in Figure 6) is, therefore, enormous and increases proportionally to the flexibility within the strategy type. Accordingly, L/S Equity and Global Macro show the largest discrepancies between the best and worst managers. For the former, it is wide-ranging flexibilities in equity ratios, but also differences in styles, regions and market capitalisations across managers. For Global Macro managers, it is the extensive flexibility in asset classes, regions and instruments – on both the long and short side – that leads to large performance differences.

In order to identify good managers from the universe of over 300 strategies, it is advisable to consider qualitative and quantitative criteria in the assessment of funds. The latter refer to past performance and includes an analysis of performance, volatility, distribution of returns (including skewness and kurtosis), correlations and behaviour in loss phases. Historical performance is even more meaningful if a manager has been able to prove himself over a complete cycle and in difficult market phases (eg the 2008 Global Financial Crisis, the Taper Tantrum of 2013 or the COVID-19 crash of 2020).

Qualitative analyses are mainly based on interviews with portfolio managers or other members of the investment or risk management team. It is particularly important to understand the personality of a manager, team structures and the investment process, as well as to evaluate risk management approaches. The results of the quantitative and, above all, qualitative analysis help an investor to assess whether the success factors are given by the investment approach and appear to be repeatable or whether chance has made a decisive contribution to this success.

5. Portfolio construction

When putting together a liquid alternatives portfolio, it is important to combine the strengths and capabilities of individual managers – which were identified during the manager selection process – in a way that is promising and in line with the investment objectives set. Consequently, approaches should not only be compared with each other, but analyses should also be developed to assess the added value of strategies in the context of an existing portfolio – taking into account the investments already used in that portfolio. Strategies should be combined in such a way that minimises the occurrence of simultaneous phases of loss. 

In order to achieve the desired diversification effects in the overall context of a multi-asset portfolio – in contrast to bonds and equities – alternative strategies should not replicate the risk/return profiles of the conventional asset classes, but should complement them in a targeted manner. Long/short equity strategies can serve as an example here, which should initially focus on different styles, segments, regions or market capitalisations for diversification among themselves. To achieve the diversification effect from a pre-existing pure-equity component, the same equity style should not be chosen as the focal point, but – rather – the focal point should be deliberately thought out and invested in a contrary way.

As with traditional asset classes, it is also essential to ensure sufficient diversification within alternative strategies. This is possible via strategies, as well as via the selected individual manager, in order to be able to compensate for temporarily disadvantageous market phases of a strategy or a respective manager’s approach. 

6. Management of a portfolio with liquid alternatives

In addition to the risk-adequate composition and scaling of the positions, the ongoing management of a liquid alternatives portfolio should ensure the rebalancing of the portfolio and the adequate risk management of it. The former relates – in particular – to long volatility profiles, which increase significantly in value during turbulent market phases. The realisation of these gains provides liquidity precisely when risk assets – such as equities or corporate bonds – have experienced a price correction and it appears opportune to increase them in the portfolio context. Risk management at the level of the individual strategies and managers involves the ongoing review and questioning of the quantitative and qualitative criteria that are decisive for the selection.

A sale may be triggered by more attractive strategies in the same segment or may become necessary for reasons inherent in the strategy. For example, changes in the portfolio management team, inexplicable developments in the returns profile or adjustments to the investment approach make a fundamental reassessment of the selected manager necessary. Experience has shown that an investment horizon of at least three years is necessary to assess the results – in order to give the selected manager the opportunity to fully showcase their returns and diversification potential. 

Conclusion: mastering product selection and generating added value for the portfolio with liquid alternatives

For successful integration into multi-asset approaches – alongside a basic understanding of the strategies, their instruments and flexibility – access to managers for a comprehensive review is crucial. This provides the basis for a correct classification of the strategies.

A sound investment process and a portfolio construction oriented towards the rest of the portfolio complete the necessary steps for a successful integration of liquid alternatives. In the current environment of historically low interest rates, alternatives are in demand that offer stabilisation and hedging in equity market corrections, as well as the necessary diversification in an environment of rising interest rates.

The targeted use of liquid alternatives as liquid, regulated and transparent strategies can sustainably improve the risk/return profile of a multi-asset strategy. Strategies with a hedging character and strategies with a defensive profile appear to be particularly interesting as partial substitutes for traditional bond profiles, especially within the framework of more defensive multi-asset strategies

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Liquid alternatives: What to consider when looking for the right manager?