As the market regime strays ever further from the stable, low-volatility environment of a decade ago, investors appear increasingly keen to look beyond traditional asset allocation methods and dig into the underlying drivers of return in their portfolios.
The increasing adoption of the ‘total portfolio approach’ (TPA) – long used among institutional investors but now more widely adopted – is indicative of this shift. Under this approach, allocators consider how individual investments’ risk and return interact and contribute to a portfolio’s total risk and return, rather than taking the ‘strategic asset allocation’ (SAA) route of treating asset classes in isolation and allocating to set proportions of ‘equities’, ‘bonds’ and other buckets.
This shift in approach opens the door for liquid alternatives. As discussed in my previous column, liquid alternatives focus on accessing complementary sources of return to traditional assets, such as equities and bonds, that will behave differently from them across a range of market environments. As such, they are an attractive option for those looking to diversify, while retaining the flexibility to transfer nimbly between opportunities as they arise.
Liquid alternatives really originated from the hedge fund world. For many years, hedge funds focused on exploiting structural risk premia in the markets to generate uncorrelated returns, such as relative value or volatility trading. Barriers such as lock-up periods and high fees, however, kept these strategies beyond the reach of most investors.
Quantitative strategies
Over time, though, banks were able to analyse hedge fund trades and how they were accessing the structural premia. Using their significant trading and research infrastructure, they packaged these strategies in purely quantitative, rules-based indices, known as quantitative investment strategies (QIS). The birth of QIS effectively democratised these strategies – and it has since expanded rapidly into an estimated trillion-dollar market.
Ironically, the biggest customer for these strategies is the very industry QIS were built to compete with – hedge funds. Of course, in being rules-based and passive, they lose the human discretion that can help (or hinder) the strategy’s returns.
Nevertheless, the low cost and efficiency of QIS mean that money can be moved quickly, as some opportunities arise and others fall out of favour. Furthermore, they are a convenient way to access strategies in new asset classes, without having to build out the infrastructure to run the trading inhouse.
“Under the ‘total portfolio approach’, allocators consider how individual investments’ risk and return interact and contribute to a portfolio’s total risk and return.
‘Liquid alternatives’ encompasses strategies with a wide variety of return drivers, meaning investors can select strategies that are uncorrelated to their existing exposure, whether that be gold, infrastructure or even private market investments.”
Still, the availability of liquid alternatives through QIS has ramifications for ‘normal’ investors too. These are tools that can be incorporated into portfolios to make them more durable through diversification. The case for those using a TPA strategy is clear but, for SAA allocators, alternatives are crucial to diversify a portfolio – and yet it is equally vital to diversify within the alternatives allocation, such that you have the greatest chance of protection in a wider range of market stress environments.
‘Liquid alternatives’ encompasses strategies with a wide variety of return drivers, meaning investors can select strategies that are uncorrelated to their existing exposure, whether that be gold, infrastructure or even private market investments. Moreover, the liquidity of these strategies means they can be adjusted between them to reflect the changing risks of your portfolio.
If, for example, a portfolio becomes more exposed to a spike in volatility, you can quickly switch out of a volatility carry strategy (which is short volatility to capitalise on the fact that volatility usually realises lower than is implied in options prices), in favour of a long volatility strategy that can help to protect the portfolio, if this shock were to materialise.
Portfolio implementation
An important consideration is how to implement these strategies in a portfolio. Some investors use liquid alternatives as ‘building block’ allocations alongside their other investments. Here, a liquid alternatives strategy needs to be scaled to target a high enough level of volatility, such that the return justifies the capital allocation – but without being so high as to significantly increase overall portfolio risk.
The other method of implementing liquid alternatives – popular among larger, institutional investors – is as an overlay. This is a capital-efficient solution where the strategy sits on top of other investments in the portfolio, providing targeted exposures without requiring full capital allocation.
Many investors use this method to deploy ‘portable alpha’ strategies, where strategies designed to deliver alpha are placed on top of a simple index, providing a separate source of alpha alongside the beta return from the underlying market exposure.
In an environment where traditional diversification is increasingly challenged, liquid alternatives offer investors a flexible and scalable way to access a broader set of return drivers. Whether implemented as standalone allocations or efficient overlays, these strategies enhance portfolio resilience by incorporating sources of return that behave differently across market cycles.
As adoption of the TPA continues to grow, the ability to dynamically allocate across both traditional and alternative risk premia will likely become a defining feature of successful portfolio construction. For investors willing to look beyond conventional asset class boundaries, liquid alternatives are not just a complement to existing portfolios – they are an essential component of a more robust and adaptive investment framework.
Tom May is CEO and CIO at Atlantic House, an asset manager specialising in risk-managed derivative solutions
