Investors are now facing a very different market environment from the one that has driven portfolio construction for the past three decades. With inflation and interest rates no longer subdued and once-relied-upon correlations between asset classes being regularly tested in recent years, investors have realised the need for greater diversification.
As a consequence, liquid alternatives have become central to conversations on constructing portfolios to absorb the trials of today’s markets. Liquid alternatives encompass a broad range of strategies that seek sources of return structurally distinct from traditional assets such as equities and bonds.
Within this universe, dispersion strategies focus on alternative risk premia, which are persistent sources of return arising from fundamental and identifiable characteristics or mechanics of the market. A classic example is the idea of simultaneously taking long positions in high-interest-rate currencies while shorting lower-yielding currencies to capture the interest rate differential.
Volatility risk premium
Many strategies make use of the volatility risk premium – that is, the idea option prices ‘imply’ a greater volatility for the market in the future than is then realised. Systematically harvesting this premium gives investors a source of return that does not require equity markets to rise. With any strategy, however, prudent risk management and sizing are important.
While the volatility risk premium can be a useful source of return in calmer markets, if volatility spikes then the strategy is susceptible to sizeable losses. Investors can mitigate this risk by using signal-based strategies that ‘turn off’ at certain thresholds. Obviously, the efficacy of these strategies then hinges on the reliability of the signal.
Dispersion strategies have recently attracted significant attention as investors continue to place their bets on the winners and losers of the AI revolution. This approach involves selling the volatility of an index and simultaneously buying the volatility of the underlying stocks in that index.
The rationale here is that index options are relatively expensive, and there is often a cancellation out of larger moves by constituents at an overall index level. Dispersion strategies can benefit from the offset between strong individual stock moves and opposing large index moves.
“The old saying has it that diversification is the 'only free lunch in finance’ – but diversifying with assets that correlate in times of market stress can cost investors dearly.
Liquid alternatives can introduce new drivers of return into portfolios and reduce investor reliance on a small set of macro variables.”
The need for greater diversification was never more apparent than in 2022, when equities and bonds fell in tandem, often leaving investors with lower risk tolerance worse off than those with higher risk tolerance. The old saying has it that diversification is the ‘only free lunch in finance’ – but diversifying with assets that correlate in times of market stress can cost investors dearly.
The true test of a portfolio’s diversification is when normal correlations between assets break down. This is what we saw in 2022: equities fell as Russia invaded Ukraine and inflation rates spiked – and bonds fell along with them. With bond yields unlikely to go much lower in a near-zero rate environment, liquid alternatives would have been a useful tool in this environment, as a broad asset class, including some strategies that can perform in an environment of rising interest rates.
Key to portfolio construction
Of course, these strategies cannot perform in every market environment. The key to solid portfolio construction is simply that, if you own things that increase in value at different times and in different environments from other assets you own, you have a more diversified portfolio – and this will likely help long-term outcomes.
And this is where liquid alternatives can help – introducing new drivers of return into portfolios and reducing investor reliance on a small set of macro variables. Even within the liquid alternatives space, there is a huge range of strategies that may be suited to different environments. A strategy aimed at providing cheaper tail protection than a vanilla ‘put’ will behave very differently from one focused on extracting the volatility risk premium.
It is also important to note that liquid alternatives are not necessarily about being low-volatility instruments. To have a meaningful impact on portfolios, you have to expose yourself to some volatility. With an annual volatility of 2 or 3, you are going to struggle to make much of a return even in favourable environments.
Where liquid alternatives can help is that by providing uncorrelated returns to other asset classes, you can have individual components of portfolios with fairly high volatility – yet a portfolio with a much more moderate volatility overall.
Tom May is CEO and CIO at Atlantic House, an asset manager specialising in risk-managed derivative solutions
