Liquid Alternative Strategies (Liquid Alts)

Liquid alternative strategies (“liquid alts”) refer to alternative investment strategies that are available through vehicles that provide daily liquidity, such as mutual funds and exchange-traded funds (ETFs).

These strategies often include, but aren’t limited to, long/short equity, global macro, market neutral, event-driven, and managed futures.

Their inclusion in a portfolio aims to achieve diversification benefits, reduce volatility, and enhance risk-adjusted returns

These strategies aim to offer investors diversification beyond traditional asset classes and the potential for enhanced returns, especially during volatile or declining markets.

They are designed to provide risk-adjusted returns and could serve as a hedge against market downturns due to their low correlation with traditional investments like stocks and bonds.

Table of Contents

Liquid Alternative Strategies

Liquid alt strategies include:

Long/Short Equity

This strategy aims to profit from both rising and falling stock prices. Managers take long positions in stocks expected to appreciate and short positions in those anticipated to decline. This approach can potentially generate returns in up or down markets while potentially reducing overall portfolio volatility.

Global Macro

Global macro managers take positions in diverse financial instruments (equities, bonds, currencies, commodities) based on their analysis of broad economic and geopolitical trends. They seek to profit from major market shifts caused by factors like interest rates, inflation, and political events.

Event-Driven

This strategy seeks to capitalize on the price inefficiencies that often surround corporate events like mergers, acquisitions, restructurings, or bankruptcies. Managers analyze these events to identify potential opportunities as markets may take time to correctly price the impact.

Relative Value

Relative value strategies aim to exploit temporary price differences between related financial instruments. For instance, a manager might focus on discrepancies between a company’s stock and its options, or between different bond issues from the same issuer.

Managed Futures

Managed futures strategies involve trading futures contracts across various asset classes (commodities, currencies, bonds, etc.). They use technical analysis and historical trends to capitalize on both rising and falling markets, providing a valuable diversification tool.

Multi-Strategy

This broad strategy offers significant flexibility by combining several of the aforementioned approaches within a single fund. Multi-strategy funds aim to provide diversification and potentially reduce risk by allocating investments across multiple liquid alternative strategies.

Merger Arbitrage

Merger arbitrage focuses on companies involved in announced mergers or acquisitions. Investors buy shares in the target company at its current market price and hope to profit when the stock price rises to reflect the agreed-upon takeover price after the deal closes.

Convertible Arbitrage

Convertible arbitrage involves taking long positions in a company’s convertible bonds (which can be converted into shares) while simultaneously shorting the company’s common stock. Managers aim to profit from pricing inefficiencies that exist between the two securities.

Distressed Securities

This strategy involves investing in the debt or equity securities of companies experiencing financial difficulties or bankruptcy proceedings. The bet is on a turnaround, with improving conditions leading to price appreciation in the distressed securities.

Market Neutral

Market-neutral strategies strive to eliminate market risk (beta) from the portfolio by taking offsetting long and short positions that balance each other out. These strategies aim to generate profits independent of overall market direction.

Option Strategies

Option strategies rely on complex options trades to profit from perceived mispricing in the market. This can involve selling volatility (betting markets will remain calm), or strategies that capitalize on expected dividend payments or corporate actions.

Arbitrage

Arbitrage strategies strive for near-riskless profits by exploiting market inefficiencies. Managers simultaneously execute offsetting trades in related securities, locking in a profit from the temporary price discrepancy.

Risks of Liquid Alternative Strategies

Despite their potential benefits, liquid alternatives also carry risks and challenges.

They have unique risk profiles and may have different levels of exposure to public markets, as well as systematic and idiosyncratic risks. It’s important for investors to understand these risks and consider how liquid alternatives fit into their overall investment strategy.

The success of these strategies depends on the manager’s skill and the market environment, and they are typically used by sophisticated investors who understand the risks associated with these types of investments.

Example

Here’s a specific example of a liquid alternative trade using a managed futures strategy:

Scenario

Market Trend: The price of crude oil appears to be in a strong upward trend, fueled by increasing global demand and potential supply disruptions.
Managed Futures Strategy: A managed futures fund specializing in commodities could employ a trend-following strategy.
The Trade:
1. Analysis: The fund’s technical analysis confirms a bullish trend in crude oil prices.
2. Execution: The fund buys multiple crude oil futures contracts, essentially betting that the price of oil will continue to rise.

How the Trade Can Profit

If the bullish trend continues, the price of crude oil futures will rise. The fund can then sell its futures contracts at a higher price, locking in a profit.

Example Outcome

Let’s say the fund bought the futures contracts at $80 per barrel.
If the oil price rises to $90 per barrel, the fund could sell the contracts for a profit of $10 per barrel (minus transaction costs).

Important Notes

This is a simplified example. Managed futures funds often trade a wide range of commodities and other assets, using complex models to identify trends.
Trends can reverse unexpectedly, leading to losses. That’s a major risk of this strategy.
Many liquid alternative funds offer daily liquidity; you could buy or sell shares of the fund itself on an exchange.

Liquid Alts in a Balanced Portfolio Setup

A balanced beta or all-weather portfolio strategy seeks to perform well across different economic environments by balancing assets that thrive in various economic conditions.

This approach typically involves diversification across asset classes that are expected to react differently to economic changes, including stocks, bonds, commodities, and sometimes cryptocurrencies.

The goal is to create a portfolio that has a stable performance through economic cycles, including periods of growth, inflation, deflation, and recession.

Integration of Liquid Alternatives

Diversification Benefits: Liquid alternatives can offer exposure to risk factors and return streams that are different from traditional equities and fixed income. This can help in reducing the portfolio’s overall correlation to traditional markets, potentially lowering volatility and enhancing returns, especially during market downturns or periods of heightened volatility.
Risk Management: Many liquid alternative strategies, such as market neutral or global macro, have the flexibility to adjust their exposures to different market conditions. This can provide a form of built-in risk management within the portfolio, allowing for better control over the portfolio’s overall risk profile.
Enhanced Returns: Certain liquid alternative strategies aim to exploit market inefficiencies or anticipate macroeconomic trends, which can contribute to enhanced returns independent of the market direction. Including these strategies in a balanced beta or all-weather portfolio can potentially increase the portfolio’s return profile without a corresponding increase in risk.
Inflation Hedging: Strategies like real assets or commodities-focused liquid alternatives can offer protection against inflation, an important consideration for an all-weather portfolio. These assets typically benefit from rising prices, helping to preserve the purchasing power of the portfolio.

Implementation Considerations

Asset Allocation: The allocation to liquid alternatives should be carefully considered based on the overall investment objectives and risk tolerance of the portfolio. It’s crucial to balance the desire for diversification and enhanced returns with the need to manage liquidity, fees, and complexity.
Strategy Selection: Not all liquid alternative strategies are suitable for all market conditions. An in-depth analysis of the underlying strategies, their historical performance across different economic cycles, and their correlation with existing portfolio assets is essential.
Monitoring and Rebalancing: Given the dynamic nature of economic cycles and market conditions, regular monitoring and rebalancing of the portfolio are crucial to ensure that the desired risk/return profile is maintained. This may involve adjusting the allocation to liquid alternatives as market conditions change.

Q&A – Liquid Alternative Strategies

What are liquid alternative strategies?

Liquid alternative strategies are investment approaches that seek to provide higher liquidity compared to traditional alternative investments like hedge funds and private equity. They encompass a variety of strategies used by hedge funds, such as long/short equity, global macro, and event-driven strategies, but are offered through vehicles that provide daily liquidity, like mutual funds and ETFs.

What are some liquid alt strategies?

Some common liquid alternative strategies include:

Long/Short Equity: This strategy involves taking long positions in stocks that are expected to increase in value and short positions in stocks expected to decrease in value, aiming to benefit from both rising and falling markets.
Global Macro: These strategies are based on taking positions in various financial instruments such as equities, bonds, currencies, and commodities, based on macroeconomic trends.
Event-Driven: This strategy aims to profit from corporate events like mergers, acquisitions, or bankruptcies.
Relative Value: It seeks to exploit price discrepancies between related financial instruments.
Managed Futures: Involves trading in futures contracts on commodities, currencies, and other asset classes, and can profit from trends regardless of the market direction.
Multi-Strategy: This approach combines several of the strategies mentioned above to provide broad diversification and flexibility.
Merger Arbitrage: This strategy involves investing in companies that are the subject of a merger or acquisition, aiming to profit from the price discrepancy between the current market price and the acquisition price once the deal is closed.
Convertible Arbitrage: This involves taking a long position in a company’s convertible bonds or preferred shares and a short position in the stock into which the bonds or shares can be converted, aiming to exploit pricing differences between the two securities.
Distressed Securities: Investing in the securities of companies that are in distress or bankruptcy, on the belief that the company’s situation will improve, leading to an increase in the security’s price.
Market Neutral: Aims to remove market risk from the portfolio by taking long and short positions in such a way that the overall beta of the longs and shorts is close to zero.
Option Strategies: Utilize options to take advantage of perceived discrepancies in market valuation. These strategies can include selling volatility or trading options based on expected dividend payments or corporate actions.
Arbitrage: Seeks to exploit inefficiencies in the market by making simultaneous trades that offset each other to gain risk-free profits.

These strategies are characterized by their daily liquidity and transparency, making them more accessible to a wider range of investors, including retail investors who may not meet the high minimum investment requirements or be able to commit to the lock-up periods associated with traditional hedge funds.

How do liquid alternatives differ from traditional investments?

Liquid alternatives differ from traditional investments in that they often employ strategies that are not correlated to the stock or bond markets, providing potential risk mitigation and diversification benefits. Traditional investments, like stocks and bonds, typically have a long-only approach and are subject to market fluctuations, whereas liquid alternatives can use more complex strategies including short selling, leverage, derivatives, and arbitrage.

What is the purpose of using liquid alternative strategies in a portfolio?

The purpose of using liquid alternative strategies in a portfolio is to achieve diversification, manage risk, and potentially enhance returns. By including investments that are less correlated with traditional market indices, investors can reduce the overall volatility of their portfolio and protect against market downturns.

Can liquid alternatives enhance portfolio diversification?

Yes, liquid alternatives can enhance portfolio diversification because their returns are often uncorrelated with those of traditional asset classes. This means that when stocks or bonds are performing poorly, liquid alternatives may still provide positive returns, thereby smoothing out the portfolio’s performance over time.

What are the potential risks associated with liquid alternative investments?

The potential risks associated with liquid alternative investments include complexity risk, as the strategies can be difficult to understand; leverage risk, if the strategy involves borrowing to increase potential returns; and liquidity risk, despite being more liquid than traditional alternatives, under certain market conditions, some liquid alternatives may still be difficult to sell quickly at a fair price.

How accessible are liquid alternative investments to individual investors?

Liquid alternative investments are generally more accessible to individual investors than traditional alternative investments due to lower minimum investment amounts and the elimination of accreditation requirements. They are often structured as mutual funds or ETFs, which are widely available to retail investors.

What types of assets do liquid alternative funds typically invest in?

Liquid alternative funds may invest in a wide range of assets, including equities, bonds, commodities, currencies, derivatives, and other financial instruments. The specific assets depend on the strategy employed by the fund.

How do market conditions affect liquid alternative strategies?

Market conditions can significantly affect liquid alternative strategies as these strategies often aim to capitalize on market inefficiencies, trends, or specific events. Some strategies may perform better in volatile markets, while others may be designed to profit from stable or rising markets.

What are some common liquid alternative investment vehicles?

Common liquid alternative investment vehicles include liquid alternative mutual funds, exchange-traded funds (ETFs), and closed-end funds. These vehicles offer daily liquidity and are regulated by authorities like the SEC, making them suitable for a wider range of investors.

How do fees for liquid alternative investments compare to traditional investments?

Fees for liquid alternative investments can be higher than traditional investments like index funds due to the complexity of the strategies and active management involved. However, they are typically lower than the fees charged by traditional hedge funds.

Can liquid alternatives protect against market volatility?

Liquid alternatives can potentially protect against market volatility by employing strategies that are not directly linked to the performance of the stock or bond markets, thereby offering a hedge during periods of high volatility.

How liquid are liquid alternative investments?

As the name suggests, liquid alternative investments offer high liquidity, allowing investors to buy and sell shares on any trading day. This contrasts with traditional hedge funds, which often have lock-up periods and other restrictions on withdrawals.

What role can liquid alternatives play in retirement planning?

In retirement planning, liquid alternatives can play the role of risk diversifiers and return enhancers. By incorporating these strategies, retirees can potentially reduce the impact of market downturns on their portfolios, providing a smoother income stream.

Are there regulatory considerations for liquid alternative investments?

Yes, liquid alternative investments are subject to regulatory considerations. In the United States, they must comply with the Investment Company Act of 1940, which imposes various restrictions on leverage, liquidity, and concentration of investments to protect investors.

How do investors typically use liquid alternatives in asset allocation?

Investors typically use liquid alternatives as a complement to traditional asset classes within an asset allocation framework. They are often allocated a portion of the portfolio that is separate from equity and fixed-income investments, serving as a diversification tool to potentially improve the risk-return profile of the portfolio.