Content provided by Grant Engelbart, CFA, CAIA, Portfolio Manager
One of our latest investment themes, Be Creative, emphasizes the use of alternative assets in portfolios. Alternatives is a broad and often confusing category of investments that encompasses unique assets, such as commodities, and alternative strategies, often called liquid alternatives, packaged in a systematic way. Some clarification may be helpful. (For more information about commodities and real assets, please refer to our white paper on the topic.)
First, some definitions:
Short or short sale — the opposite of a long position. This requires borrowing a stock and then selling it, benefiting from price declines. This can be done on nearly all securities but is usually most efficient in futures markets.
Hedge — a way to reduce the risk of a position, typically by using a short position to offset a long. For instance, a fund could own a group of value stocks but then partially hedge their risk by shorting the overall stock market by an equal amount.
Arbitrage — taking advantage of a pricing discrepancy that is likely to converge. It typically includes buying and selling two securities in different markets or forms that are expected to be priced similarly.
What are alternative strategies?
Alternative strategies are typically a combination of stocks, bonds, commodities, and currencies packaged in a systematic manner, often with a hedge. The goal of these strategies is to take advantage of certain market anomalies (similar to equity factors). They often engage in various forms of arbitrage, which will be described later. These strategies historically have been prominent in private form — through a hedge fund or commodity trading advisor (CTA). These usually can only be accessed by high net worth, accredited investors. Liquid alternatives are similar but become available in mutual fund or ETF form, available to the investing public, hence the name “liquid” alternatives. Liquid alternatives have no lock-ups and typically offer daily liquidity, unlike private structures.
What are examples of alternative strategies?
There are several prominent categories of alternative strategies detailed below. Other strategies may not be appropriate for public market investing as their securities may be illiquid or require substantial ownership hurdles, such as owning physical land or cargo. The major categories include:
- Bear market
Bear market strategies rely on the heavy use of short-selling and are typically near 100% short most of the time. These funds can be used to add a hedge to a portfolio or bet on market declines.
As the name implies, these strategies will go long or short on a variety of different currencies. One particular strategy that is often applied is the “carry trade.” The strategy goes long on high-yielding currencies and shorts (or borrows in) low-yielding currencies, collecting the spread.
- Long-Short Equity
These strategies are fairly intuitive by nature but can vary widely in risk. The strategy is to invest in, or go long on, stocks that are attractive, and sell, or short, stocks that are not attractive. A lot of managers in this category will use factors such as value to determine their longs and shorts. If the manager has an equal amount of long and short positions, they are typically considered market neutral (the next category). These strategies can take on very low or very high market risk depending on how much they are short.
- Market Neutral
Market-neutral strategies generally hedge out all of their market exposure and focus on generating alpha (excess return). Certain merger arbitrage strategies will fit into this category. Merger arbitrage involves buying a company that is going to be acquired and then selling short the company doing the acquiring (or an applicable sector index). These strategies capture the usually small but generally reliable spread between the current market price and acquisition price.
Multialternative strategies combine various alternative strategies into one fund in order to mitigate risks and enhance returns. Some multialternative funds simply attempt to match the returns of a broad hedge fund index by using a quantitative process.
- Managed Futures
Futures contracts are derivatives that trade based on the price of an equity index, bond, commodity, or currency. They provide a high level of liquidity and trading flexibility. Managed futures strategies use these contracts to gain exposure to different types of asset classes. They usually go long and short, typically based on momentum.
The final category is a catch-all for strategies that utilize options. These wide-ranging strategies use options to generate income, provide downside protection, or attempt to do both.
Why use liquid alternatives?
There are several important reasons to include alternatives in portfolios:
- Diversification. Alternatives should be less correlated, or hopefully uncorrelated, with stocks and bonds. This can help reduce overall portfolio risk.
- Risk management. Many alternative strategies are designed to perform their best in down periods for the stock and/or bond markets.
- Unique exposures. Liquid alternatives can provide access to sources of return that are unavailable to standard equity and bond investors.
- Liquidity. Private structures, such as hedge funds and commodity trading advisors (CTAs), typically don’t allow for daily, and especially not intra-day, liquidity. ETFs and mutual funds that engage in these strategies will almost always be able to offer a high level of liquidity.
- Cost. Because of the systematic nature of these strategies and the product wrapper (ETF/mutual fund), they are typically much cheaper than private alternatives. ETFs provide an even lower cost, which has shown some benefits so far.
Hopefully this was helpful in better understanding liquid alternatives. As stocks and bonds become more expensive from a valuation perspective, we believe alternatives will play an increasingly important role in investor portfolios.