Higher for longer, volatility, geopolitical tension – today’s investment environment is a world away from the ultra-low interest rates and rallying equity markets of the 2010s. Could liquid alternatives provide much-needed diversification from bonds and equities? 

The creator of modern portfolio theory, Harry Markowitz, described diversification as the only free lunch in investing. With fears that bond and equity markets could increasingly move in tandem, investors are forced look to different asset classes if they want theirs. Many have sought out private market assets, which often have the added bonus of steady cash flows, but what if these allocations are already full? 

Some say liquid alternatives could be the answer to this dilemma. Hedge funds form the core of this group of strategies, but others have grown around them, from overlays and portable alpha to alternative risk premia. Despite their name, the level of liquidity in such strategies can vary considerably, with lock-in periods of up to a year, though some investors require monthly or more frequent dealing. 

Hedge funds are complex, so staying liquid could mean different things. Potentially, liquidity could mean keeping a certain proportion, for example 10% of the portfolio, liquid in case anyone wants to disinvest rather than selling positions, says Nick Prouvost, a former investment consultant turned professional trustee for Vidett.

“The problem is when you really need the liquidity in times of a crisis, like in the gilts crisis, that 10% could get exhausted pretty quickly, and then you might find yourself in a position where you can't get your money out,” he opines.

But under normal market conditions, liquid alternatives are true to their name, which could be useful for defined benefit schemes that want to redeem their investment, for example when they go to buyout, he says.

Generally speaking liquid alternatives are better suited to DB pension funds opting for run-on than those going to buyout, however, as those that run on would be looking for a margin above corporate bonds to close any funding gap or build surplus.

Even so, there will still be trustees that might hesitate when it comes to hedge funds. During the global financial crisis, some pension funds struggled to redeem their hedge fund investments, and the era has left its marks on anyone who managed money. Post-2008, many pension scheme boards decided to only invest in solutions they understand.

Prouvost says understanding an investment strategy is important but believes trustees boards now have a better chance of understanding hedge funds because they have become more sophisticated through the growing use of professional trustees. The liability-driven investment gyrations of 2022 once again brought into sharp focus the need to have a thorough understanding of pension investments, including how a strategy will react in a crisis, he notes.

That need for clarity is even greater for defined contribution schemes, which invest members’ money and so need to explain investments to them in a way they can understand – although DC too has become increasingly professionalised through master trusts and their boards.

“So it's kind of a play between those two things as to whether or not these more complex strategies are more or less appropriate,” says Prouvost.

Ultimately, with hedge funds and similar products providing diversification, each scheme has to think about it in the context of its wider strategy, membership and the goals of the scheme. Prouvost advises trustees to consider how much return they are trying to generate and how much diversification they already have – also taking into account that diversification can suppress returns.

Trustees will want to go into these strategies with their eyes wide open, but there is a place for liquid alternatives, he believes: “If it's done right, it could work well. It should be considered carefully from a point of view of member engagement, trustee understanding and the context of the overall investment strategy.”

Whether liquid alternatives are suitable will depend on the scheme’s overall portfolio, since diversification is different for each scheme, agrees Dimitri Curtil, global head of multi-asset solutions at Newton Investment Management.

Liquid alternative strategies come in many guises – some offer protection, others aim for alpha. On the whole, they try to provide diversification through low correlation to traditional markets and their ability to take long and short positions among others, although Curtil stresses that on average, they should be market neutral.

Since the Covid-19 pandemic, the ground has been fertile for almost any type of liquid alts strategy in terms of alpha generation, as inflation reared its head and there were dislocations across asset classes and economies, he says.

“Now we have different monetary policy cycles. It creates different opportunities in terms of allocating across different countries, different asset classes. And putting it very simply, the more volatility you have, the greater the opportunity set you have for the strategy,” he notes.

This new environment is not unlike the world before 2008 and has led to a revival of the toolkit of yesterday, though Curtil says today’s products and strategies are more resilient than they were then. When the GFC hit, many hedge fund strategies were doing similar things and contained hidden beta, while not all instruments that funds use now were available back then.

Liquid alt strategies are based on models, but Curtil believes investors should look to work with people that have a long track record, rather than buy strategies built on back-testing alone.

“That history and legacy of the team is very important. Usually, the teams that have done it for longer tend to have a higher chance of repeating the success going forward. To do it the right way with the right instruments takes skill,” he says.

Not all managers are as transparent as investors would like, admits Curtil, but he says many asset managers have become better, not least to understand what is going on themselves, as well as because investors are demanding it.

“In my space, where most of my clients are, I would not be able to pitch a strategy with a black box approach that I cannot explain,” he remarks. 

As well as transparency having improved, fees have come down. The ‘2 and 20’ fee structure that people still associate with hedge funds are long gone, says Toby Goodworth, head of liquid markets at consulting firm bfinance, believing a 1.6% to 1.8% management fee and 15% to 18% for performance to be more common now. Even so, some products – typically multi-manager ‘pod shops’ with high pass-through fees – could charge fees higher than 2 and 20, he adds. 

Liquid alternatives are a more involved area, they're a more complex area than traditional investments. Therefore it's not unexpected that fees would be higher,” he says. 

Fees alone should not put investors off though, he suggests: “If the return profile net of fees is useful to your portfolios and you are able to consider that absolute fee level, then you should be looking at the space.”

For Goodworth, this means allocating more than just a couple of percentage points of the total portfolio, since a small allocation has little chance of making a difference.

“If your hedge fund allocation is under 5%, you could argue that's a little bit like rearranging deck chairs on the Titanic,” he says. 

And while some endowments have allocations as high as 20%, the right answer for most investors might be somewhere between those two extremes.

There is fresh interest in liquid alternatives from investors, Goodworth says. He puts this down to both “push and pull factors”. Investors are pushed to alternatives because the global environment suggests diversifying could be prudent, but bonds do not diversify portfolios like they used to, while allocations to illiquid alternatives are mostly full. 

On the other hand, investors are pulled towards more liquid alternative strategies because they have performed well since 2020. Despite this, investor interest only picked up about a year ago but has been solid since, says Goodworth, with investor appetite mainly in the wealth space, while some DB schemes have also shown interest. 

For those that have decided to invest, choosing a manager and strategy can be difficult – Goodworth points out that there are thousands of managers and about 30-40 sub-strategies for each strategy. An additional difficulty is that performance is not benchmarked and therefore hard to compare.

This puts a greater onus on hedge fund managers to explain their strategies in an understandable way. “One of the biggest challenges the hedge fund space faces is education and training,” Goodworth says. “It's very easy to spout Greeks and jargon and make it seem incredibly complex.The skill of presenting a hedge fund strategy to an institutional investor that may include lay people on a board is actually paring it back and explaining, ‘This does this, we do it this way for this reason’. And I think there's quite a lot of variability there.”