or decades, institutional investors have incorporated alternative investments into their portfolios in a quest to manage risk, improve diversification and increase returns. For large institutional investors with a tolerance for illiquidity, alternative investments would likely include some combination of hedge funds, private equity, commodities and private real assets such as real estate, infrastructure and even timberland. For smaller and individual investors, an allocation to alternatives may simply mean a move beyond allocations to traditional stock and bond strategies. Regardless, it is clear that investors of all types and sizes are increasingly focused on the value proposition offered by alternative investments and specifically, liquid alternatives.
As the name implies, an alternative investment (like alternative medicine, etc.) should contain clear attributes that differentiate it from conventional investments, which generally can be thought of as traditional stock and bond strategies. The differentiating attributes fall into one of two categories:
- Alternative market risk exposures: Passive or actively managed investments that provide exposure to different sources of return and associated risk factors (sometimes referred to as non-traditional or alternative beta). Examples include commodities (gold) and real estate.
- Alternative investment strategies: Actively managed strategies that involve a much higher degree of manager discretion to vary allowable market risk exposures than traditional benchmark-oriented investment strategies. Alternative investment strategies may also allow for greater flexibility to take long or short positions, make significant and dynamic directional bets and use financial derivatives than what is commonly associated with traditional investment strategies. Examples include market-neutral and long/short equity strategies.
Alternative investments tap either or both of these sources of return and, in doing so, help to diversify a portfolio that is largely composed of traditional stock and bond strategies.
In addition to providing diversification, many alternative investments offer the potential for highly attractive alpha, or risk-adjusted incremental return. To be clear, the best-in-class managers of traditional active stock and bond strategies may provide attractive alpha; however, we would not call such investments alternatives, since they tend to be highly correlated with their respective stock and bond indexes. Conversely, investments that focus exclusively on capturing alternative risk exposures would largely be included within the universe of alternatives even when managed systematically, given that such strategies should provide greater diversification from traditional asset classes.
Liquid alternatives are distinguished from the broader universe of alternative investments by being offered in vehicles − most commonly mutual funds and exchange-traded funds − that provide daily liquidity and are accessible to a wide range of institutional and individual investors.
The value proposition
The rationale for considering alternative investments is documented in most investment management textbooks, and anchored in the fact that there are only two ways to achieve
a higher expected return without necessarily incurring a corresponding increase in risk: (i) improved diversification and (ii) higher alpha through active management. Alternative investments offer the potential to achieve the first, and in many cases, both of these objectives as a component within an overall portfolio.
Of course, investors need to be mindful of the risks associated with alternative investments, which will vary by sector focus, strategy, vehicle and manager. For example, an investment in a private fund may carry different types of risk than a liquid alternative due to illiquidity and other factors, such as not being subject to the same regulatory requirements as mutual funds. The risk factors of alternatives also differ from those of traditional stocks and bonds, either through alternative exposures (e.g., currency or commodity risk) or variations due to active management decision-making.
Although the results may vary substantially over time, a quick comparison of the risk and return of a traditional 60% U.S. equities/40% U.S. bonds benchmark portfolio relative to a nominally diversified portfolio over the past 10 years shows the appeal of alternative investments. In Figure 1, the former is based on a blend of the S&P 500 and Barclays U.S. Aggregate indexes, while the latter is a typical university endowment as represented by the 2011 National Association of College and University Business Officers, or NACUBO, asset allocation model.
As you can see, the NACUBO portfolio has delivered higher returns with a minimal increase in risk, as measured by the volatility of returns. This is further illustrated by the Sharpe ratio – which measures return over the “risk-free rate” divided by volatility of returns – of 0.63 for the NACUBO portfolio, compared to a 0.47 for the traditional 60/40 portfolio over the 10-year period. In short, the more diversified portfolio has exhibited better risk-adjusted returns.
However, even in this example there is potential additional value that may be achieved by further allocations to alternative investments that help diversify equity market risk in particular, as the risk profile of the NACUBO model portfolio is still dominated by equity market risk, as shown in Figure 2.
Diversification of risk exposures and alpha sources is arguably more important today than ever. As espoused by Nobel Prize-winning economist Harry Markowitz in “The Journal of Finance” in 1952, diversification offers investors the ability to potentially increase investment returns while simultaneously reducing portfolio volatility, and therefore was dubbed the only true “free lunch.” At one time, international diversification within traditional asset classes was considered a clear path to materially improved portfolio diversification. But consider how much the world has globalized over the past several generations. Improvements in fixed line communications, mobile phones and the Internet, combined with growth in global trade, capital mobility, electronic trading and international mergers of exchanges have helped create a global marketplace. To offer just one example, as shown in Figure 3, the performance of U.S. and German stocks and bonds converged since the start of the Internet age. No doubt this has had a profound impact on investors’ ability to take advantage of the “free lunch” by relying strictly on stocks and bonds.
Not only have some of the historic benefits of international diversification within asset classes eroded over time, but also returns from traditional stock and bond investments may likewise be muted over our secular horizon. This view of the world is based on the notion that the era of higher asset class returns driven by falling interest rates, excessive leverage, lower discount rates and higher equity multiples has come to an end. In effect, the efficient frontier, when measured based solely on the traditional stock and bond opportunity set, has shifted down and to the right, as illustrated conceptually in Figure 4.
In such an environment, investors are likely to be more challenged than ever in meeting their investment objectives while maintaining an acceptable level of risk. As a result, alternative investments are likely to be an increasingly important component of investment portfolios going forward due to the diversification benefits and the potential to manage the risk and/or increase expected return of a portfolio.
For investors who prefer investment vehicles with daily liquidity, do not have access to private fund structures or otherwise are limited to liquid alternative options, the rationale for liquid alternatives as a subset of the alternatives universe is clear. Even for investors who do have access to less liquid alternative investment vehicles and strategies, liquid alternatives may still offer the potential for valuable benefits as a complement to other types of alternatives. For example, the financial market crisis of 2007–2010 revealed that any portfolio too dependent on capturing the liquidity risk premium may fall victim to the cost of illiquidity during times of crisis. This has caused more than a few university endowments to re-evaluate the extent to which they rely on illiquid alternatives, particularly given the emerging choice of liquid alternatives that may accomplish many of the same portfolio objectives.
Choosing and deploying liquid alternatives
While the opportunity set for liquid alternatives is not as broad as the one available via private fund alternatives, the list of attractive liquid alternatives continues to grow. In many cases, investment managers who previously only offered alternatives in private fund structures are now offering similar strategies via a mutual fund platform. The reason is simple: Many hedge fund strategies are viable under the 1940 Act structure, and this structure appeals to investors looking for greater liquidity.
Other relatively new liquid alternative offerings have resulted from investment manager innovation, presumably in response to the demand from clients for investment options that provide the potential for higher alpha and diversification, among other possible benefits. Of course, many liquid alternative funds have been available for a longer time period, and they are now receiving a heightened level of interest from institutional and individual investors alike.
As shown in Figure 5, liquid alternatives fill an important gap between traditional investment strategies and private fund alternatives by offering the liquidity, transparency and ease of investment access that investors most commonly associate with traditional stock and bond funds. At the same time, they capture the diversification benefits and, in many cases, the potential for higher alpha of alternative investments.
Regardless of whether they are offered as private or public strategies, many alternative strategies are inherently more dependent on portfolio manager expertise − that is, a larger component of their returns may derive from active manager decisions, not market returns.
Because of this, we believe investors considering alternatives should seek managers with the following key attributes:
- Exceptional and proven manager skill
- Well defined and repeatable investment process
- Depth of research and a demonstrated ability and process to convert research themes into profitable trades
- Understanding of the underlying risk factors and the ability to dynamically adjust such exposures within the portfolio as warranted
- Trading efficiency, often enabled through economies of scale
- A robust risk management framework
- Proper alignment with investor interests
- Ability to communicate strategies to investors
Portfolio integration of liquid alternatives
We have identified two different approaches to incorporating liquid alternatives into portfolios. The first is to add liquid alternatives as a dedicated non-core allocation to “alternatives” with the objective of improving prospective risk-adjusted portfolio-level returns. These allocations themselves are increasingly diverse and may incorporate specific thematic views to help guard against rising rates, higher inflation or something as specific as a housing recovery. The impact on the broader portfolio will of course be limited if the client’s allocation to alternatives is small relative to the allocation to traditional stocks and bonds. Therefore, investors may wish to consider a sizable or increased allocation to alternatives. The increasing number of available liquid alternative options is very helpful in this regard, as a lack of ready liquidity was previously a constraining factor on allocations to alternatives for many investors.
The second approach involves a greater integration of liquid alternatives into the “core.” One example is the incorporation of absolute return-oriented alternative investment strategies that allow for much greater active management discretion, and possibly alternative risk exposures, in place of traditional benchmark-oriented stock or bond strategies. In other cases, alternative investments might serve as an attractive substitute for a 60/40 portfolio in its entirety. Actively managed, high-discretion asset allocation strategies, risk parity, and global macro strategies are popular choices for this latter type of “core” allocation.
Combining multi-asset liquid alternative strategies with tactical or thematic strategies is becoming more prevalent. No matter which approach an investor chooses, it is important to consider risk tolerance and investment objectives.
Putting it all together
The fundamental benefit of diversification has always been centered on the objective of increasing investment returns while maintaining a similar level of risk, or maintaining expected returns at a lower overall level of risk. With the erosion of the diversification benefits within traditional asset classes, alternative sources of diversification have become imperative. For those lacking the ability to venture into the less liquid alternative asset categories, liquid alternative investments can fill a critical need. Even for those who invest in alternatives more broadly, liquid alternatives may provide valuable benefits, including the ability to increase the overall allocation to alternatives while maintaining a desirable level of portfolio liquidity.
Increasingly, alternative investment choices are available in liquid, readily accessible vehicles like 1940 act mutual funds. These include a variety of different risk factor exposures, risk/return profiles and levels of active manager discretion and may serve as valuable complements to an investor’s existing portfolio. In particular with alternatives, there also may be noteworthy value in partnering with investment managers whose processes, depth and resources are best positioned for identifying and executing strategies that seek value within and across global asset classes. In whatever ways investors choose to use liquid alternatives, we believe this growing and diverse category of offerings may be key to achieving investment goals and objectives amid the myriad challenges and risks in a post-crisis and increasingly uncertain world.
ABOUT PIMCO LIQUID ALTERNATIVES
PIMCO has been offering both public and private fund alternatives for over a decade to help our clients meet their return objectives and diversify portfolio risk exposures. In the liquid alternatives category, we currently manage more than $100 billion as of 31 March 2013. Our offerings draw on our portfolio management expertise across asset classes and currently include the following alternative strategy styles: absolute return, multi-asset, long/short equity, equity market-neutral, bear market, commodity, real estate-linked and currency strategies.