The financial crisis permanently changed investors’ perceptions of important concepts such as diversification and correlation. Investors who had, up to this point, slept soundly in the knowledge they had a ‘diversified’ portfolio, found that many seemingly uncorrelated assets, such as equities and bonds, could in fact move in unison – just at the moment they needed diversification the most.

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At the heart of liquid alternatives lies a fundamental rethinking of the balance between risk and return. Investors may still retain long-term ambitions to generate income and/or capital growth but there is now also a much greater awareness of the importance of capital preservation, downside protection and genuine diversification.

A liquid alternative investment (or liquid alt) is a blend of lucrative hedge fund management strategies with the daily liquidity of a mutual fund. Liquid alts can be a substitute for traditional hedge funds, though they are often much more accessible for everyday investors.

Nearly all liquid alternative investment funds were created after the 2008 global financial crisis. The idea was to provide retail investors with portfolio diversification while also helping protect against downside, with daily exposure to a variety of alternative investment strategies. Done properly, this could reduce long-term risk and limit overall investment volatility.

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Alternative investments include a variety of assets that don’t fall into either the bond or long stock categories. This may mean real estate, commodities, derivatives, private equity, distressed debts or even fine art. However, these investments aren’t typically very liquid in nature — if an investor needed to sell off very quickly, he or she would have a much tougher time with a fine art or real estate asset than a more mainstream stock holding.

This is where liquid alternatives aim to come in. These investments are broadly accessible to investors and offer daily liquidity, like a mutual fund or exchange-traded fund (ETF). This means that they can be bought or sold on a daily basis, as opposed to traditional alternatives — many of which are redeemed on a monthly or quarterly basis, if that.  Liquid alternative strategies can enhance the risk-adjusted returns of an existing balanced portfolio. This should offer investors genuine diversification within a portfolio, reduced volatility and decorrelation characteristics, while offering potential downside protection when markets are distressed.

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A liquid alternative strategies may employ certain investment techniques that differ from traditional funds. Examples of these include: Long/short investing; leverage; derivatives.

Traditionally liquid alternatives have been viewed as a distinct stand-alone asset class, however investors are now realising the attractiveness of combining them with their traditional asset class allocation.

 

The graphic below shows how liquid alternatives can be considered alongside a portfolio’s equity and fixed income allocation.

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Note: Illustrative allocation only. The above is not meant as investment advice.

The way investors choose to use liquid alternatives will depend, however, on their particular investment objectives, since liquid alternatives have the ability to play a variety of roles within a portfolio. For example, they can provide access to diverse sources of alpha, reduce volatility and directional market risk, offer protection in falling markets and are a simple but flexible approach to enhancing diversification.

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Whatever liquid alternatives investors use, the ultimate aim for investors should be to build a well-diversified portfolio that is sufficiently robust to withstand a variety of market conditions. An integral part of this process must always be the careful evaluation of the different risk and return characteristics of liquid alternatives to determine how they may best fit within a portfolio.