Summary
Who would have known that a decade ago, equities and bonds would simultaneously embark on a record-setting streak, only interrupted by relatively mild corrections? So sustained were these rallies that for many investors, life without such spectacular returns and low volatility became a distant memory. In fact, as the last decade ended, equities reached all-time highs in the US, while multi-year highs were achieved in Europe. In many instances, stock prices outpaced earnings growth, making equities look increasingly expensive. During this period, EUR 13 trillion of government bonds also slipped into negative yield territory.3 Going forward, bonds on the current level cannot offer the same combination of portfolio protection and positive income that they once did. This has been a fascinating period of investment history. Investors could cast aside the need to diversify, manage risk or even actively invest. We fear, however, that these times might eventually come to an end. The market volatility due to the coronavirus is already a telling sign of the changed capital market environment.
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Update Magazine I/2020 |
1
The end of the equity and bond golden age
Who would have known that a decade ago, equities and bonds would simultaneously embark on a record-setting streak, only interrupted by relatively mild corrections? So sustained were these rallies that for many investors, life without such spectacular returns and low volatility became a distant memory. In fact, as the last decade ended, equities reached all-time highs in the US, while multi-year highs were achieved in Europe. In many instances, stock prices outpaced earnings growth, making equities look increasingly expensive. During this period, EUR 13 trillion of government bonds also slipped into negative yield territory.1 Going forward, bonds on the current level cannot offer the same combination of portfolio protection and positive income that they once did. This has been a fascinating period of investment history. Investors could cast aside the need to diversify, manage risk or even actively invest. We fear, however, that these times might eventually come to an end. The market volatility due to the coronavirus is already a telling sign of the changed capital market environment.
This has been a fascinating period of investment history. Investors could cast aside the need to diversify, manage risk or even actively invest.
2
How the next decade could look very different
Even before the coronavirus outbreak, we were already facing significant risks: Europe remains in dire need of progrowth fiscal and structural policies, and it is not clear if politicians are ready to tackle these challenges. The US/ China trade conflict might still evolve into a longer-term conflict for economic (and military) primacy. Lastly, central bank interventions have reached the end of their effectiveness, and central banks have limited fire power to fight the next economic downturn, which is already becoming visible in the coronavirus crisis.
Going forward, we believe the upside potential from traditional asset classes is lower, and the downside risk is higher. For long-term investors, this backdrop poses a challenge on how to position their portfolios.
3
Introducing Liquid Alternatives
In the coming decade, investors will need to balance out the different risks they are exposed to by introducing new sources of low-correlated returns to their portfolios. This will help improve their long-term risk-return profile, and help them meet their investment objectives. Liquid Alternatives can be a great tool to achieve this. By adding them, investors can increase their portfolio diversification, enhance risk mitigation and add new sources of return. In addition, they can provide this in a highly liquid fashion, giving investors the flexibility to add or decrease their positions if necessary. Liquid alternatives are also easy to integrate into an existing portfolio. This is because many liquid alternatives complement the existing asset classes investors already hold.
During a decade of rising markets and low volatility, traditional strategies have been more en vogue than liquid alternatives. The latter disappointed in 2018, even though we would argue that a negative year like 2018 is within the investment mandate for most of these strategies. After all, Liquid Alternative strategies do carry certain risks – which ultimately are the source of attractive returns over the long run. In 2019, we already saw a strong recovery for Liquidity Alternatives: based on data from Hedge Fund Research, Liquid Alternative strategies across the board posted one of their strongest years in recent history in 2019 (see Chart A/).2
A/ LIQUID ALTERNATIVE STRATEGIES SHOWING GAINS IN 2019 – AFTER THE OPPOSITE IN 2018
in USD, 01/19–12/19
in USD, 01/18–12/18
Source: MPI/Morningstar. Data as at 31.12.2019. A performance of a strategy is not guaranteed and losses remain possible.
4
How investors can classify the different types of liquidity alternative strategies depending on their objectives
Liquid Alternatives come in different flavours and serve different purposes. In order to optimise ones portfolio, it is therefore crucial to understand the characteristics and risk-return profiles of the various Liquid Alternatives strategies (see Chart B/). We cluster them into three categories.
Diversifier strategies
During bear market events, these strategies can generate
positive returns and stabilise an overall portfolio, offering
downside protection for investors. They include CTAs
(Commodity Trading Advisors), managed futures and
global macro managers. They are directional strategies
that take advantage of short and long-term trends and,
therefore, have flexibility in which direction they invest –
both long and short.
They can also dynamically adjust their exposures to
capture market movements. To achieve this, they often use
liquid instruments, such as futures or forwards on major
stock market indices or government bonds.
Risk reducer strategies
These strategies can offer a more stable return profile than
directional long-only funds because they largely hedge out
market beta. They typically avoid taking any directionalmarket
exposure, but instead take relative-value positions.
In addition, they offer very low correlation to equity and
fixed income markets.
This segment is well represented by equity market-neutral
strategies, which use both long and short positions to take
advantage of valuation discrepancies. The typical risks
associated with these strategies are sector and factor
rotations that can be triggered by technical or
macroeconomic data. Risk mitigation can be achieved by several measures, such as hedging out market risk, and
actively managing portfolio exposure and single positions
in times of stress.
Premium collector strategies
These can help enhance risk-returns for the underlying
portfolio, offering access to additional sources of risk
premia. Often, they will take relative-value or even
directional positions in securities affected by certain events,
capital flows, hedging or other capital market activities.
A merger arbitrage fund is a good example. This fund
would typically buy shares of a takeover target in a cash
deal acquisition, which in most cases trades below the
acquisition price. They also take a short position in the
acquiring company to hedge out the acquirer’s stock if the
deal will be paid in shares. The merger arbitrage fund
takes on the risk of the deal falling through, and in return
it collects a premium once the deal goes through.
B/ STRATEGIES AND ASSOCIATED CATEGORIES OF SELECTED LIQUID ALTERNATIVES
5
How investors can combine the various types of Liquid Alternatives in order to optimise their portfolios
Investors can blend these three categories types or use them separately in order to achieve their return targets by improving their portfolio efficiency. Depending on the risk appetite and desired return expectations, investors could utilise alternative premium collector strategies as the main return generator, complement them with risk reducers to stabilise the return profile over time, and include diversifiers to additionally enhance and diversify the return streams. Integrating Liquid Alternative Strategies into an existing portfolio must be individually tailored for each investor while taking their investment objectives into consideration (see Chart C/). For a typical European institutional investor we believe that a return of 2% p.a. above money market rates with an expected CVaR (95%)3 of –4.2% is realistic for this diversified portfolio over a market cycle.
In order to assess this portfolio’s robustness from a forwardlooking perspective, we have made use of risklab's established capital market model, which on a regular basis produces economically consistent forward-looking scenarios for various risk factors as well as asset classes, to which we added our sample Liquid Alternatives portfolio’s corresponding strategies. We then evaluated the impact of adding 10% and 20%, respectively, of this sample portfolio to a traditional asset allocation of equities and bonds (“Base SAA”). In all instances, the risk-return profile of the traditional 70:30 equity-bond portfolio improved. The proportional decrease in bond and equity positions in favour of Liquid Alternatives can lower volatility while keeping the same level of expected return (“Risk-Reducing SAA”). By financing the allocation to Liquid Alternatives solely through bonds, investors can achieve a higher expected return while maintaining a similar risk level (“Return-Enhancing SAA”).
C/ USING LIQUID ALTERNATIVES TO IMPROVE A PORTFOLIO RISK-RETURN PROFILE4
Source: risklab
6
Summary
As we enter a new decade, Liquid Alternatives are staging a comeback. Investors face a higher-risk and lower-return landscape, which means that they need to take a far more considerate and active approach to investing than they did in the previous decade. Given this lacklustre outlook, it becomes even more important to optimise an investor’s portfolio by adding diversifying strategies. This can not only enhance portfolio returns, but also mitigate portfolio risk by reducing volatility and providing potential downside protection when markets are stressed.
As we have shown above, Liquid alternatives are an attractive addition for a traditional portfolio. Investors need to be mindful, however, of their goals when utilising Liquid Alternatives. Some investors might implement a Liquid Alternatives allocation through a diversified and risk-balanced portfolio of Liquid Alternative strategies—ideally covering diversifiers, risk reducers and premium collectors. Other investors might prefer a more targeted allocation to select Liquid Alternative strategies to fulfil their specific needs.
1omberg Barclays Negative Yielding Debt Index Market Value; as of Feb 28, 2020. Past performance is not a reliable indicator of future results.
2Hedge Fund Research, MPI/Morningstar. As of: 31 December 2019. A performance of a strategy is not guaranteed and losses remain possible.
3Conditional Value at Risk at the 95% confidence interval over a one-year time horizon
4Asset allocation of sample is for illustrative purpose only, it is based on forward looking scenarios and is not an indication of future results.
Investing involves risk. The statements contained herein may include statements of future
expectations and other forward-looking statements that are based on management‘s current
views and assumptions and involve known and unknown risks and uncertainties that could cause
actual results, performance or events to differ materially from those expressed or implied in such
statements. We assume no obligation to update any forward-looking statement. The value of an
investment and the income from it may fall as well as rise and investors may not get back the full
amount invested. There is no guarantee that the strategy will succeed and losses cannot be ruled
out. Investors may not get back the full amount invested.
The volatility of fund unit prices may be increased or even strongly increased. Past performance
is not a reliable indicator of future results. If the currency in which the past performance is
displayed differs from the currency of the country in which the investor resides, then the investor
should be aware that due to the exchange rate fluctuations the performance shown may be
higher or lower if converted into the investor’s local currency. The statements contained herein
may include statements of future expectations and other forwardlooking statements that are
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