Liquid Alternatives: Considerations For Portfolio Implementation by Justin Blesy and Ashish Tiwari, PIMCO

Since the financial crisis, investors have poured nearly half a trillion dollars into liquid alternative strategies – typically mutual funds and ETFs that deploy non-traditional strategies once reserved for large institutional investors.i These vehicles offer the potential for diversification, downside risk mitigation and attractive risk-adjusted returns with the transparency and daily liquidity many investors desire. Liquid alternatives have been a democratizing force for investors, and we believe today’s market environment arguably has only made them more attractive.

Yet implementing liquid alternatives in portfolios presents a complex set of challenges as risk, return and fee profiles vary widely across strategies. In the pages that follow, we present an overview of liquid alternative strategies and considerations for their implementation in portfolios.

Liquid alternatives: A search for returns and diversification

Typically packaged as mutual funds or ETFs, liquid alternatives bring many nontraditional investment strategies once reserved for large institutional investors to a broader investor base. Assets in U.S. liquid alternative strategies have jumped from less than $100 billion in 2008 to more than $500 billion at the end of 2014,ii with potential for continued growth ahead. Their popularity reflects the turbulence many investors endured with traditional stock and bond portfolios in recent decades, as well as muted forward-looking return expectations for these asset classes.

The experiences of the past two decades left many investors searching for additional sources of return and diversification. They learned, often the hard way, that the majority of their portfolio’s return and risk had been driven by equities, an asset class prone to significant drawdowns. Although a traditional 60/40 portfolio has a 60% capital allocation to equities, risk is driven almost entirely by equities given that equities are much more volatile than bonds. While this can lead to strong performance during equity bull markets, as has been the case in the U.S. since 2009, it can also leave portfolios exposed to severe drawdowns (see Figure 1).

Liquid Alternatives

Liquid Alternatives

At the same time, unstable correlations across many assets have left investors with fewer reliable portfolio diversifiers. For example, the sharp increase in the correlation of stocks and bonds during 2013’s “Taper Tantrum” left many investors concerned about the ability of fixed income allocations to diversify their portfolio’s equity risk.

These significant market drawdowns over the past 15 years have resulted in much lower returns than investors experienced in the 1980s and 1990s. During those decades, a traditional 60/40 portfolio had an average annualized return of 13.7% over rolling five-year periods. In contrast, since 2000, investors received on average 5.9% and forward-looking expectations are even lower given today’s starting conditions (see Figure 2). As of 30 June 2015, 10-year U.S. Treasury yields of 2.4% were near historical lows, and in stocks, the S&P 500 dividend yield was 2.1% with cyclically-adjusted P/E ratios near all-time highs. This stands in stark contrast to the conditions that preceded the strong bull market in stocks and bonds in the 1980s and 1990s, when10-year Treasuries peaked near 16%, dividend yields approached 6% and cyclically-adjusted P/E ratios were near all-time lows. Today’s environment of lower yields, higher valuations and slower global growth has led to modest long-term return expectations for stocks of 4.5% and for core bonds of 2.5%, according to PIMCO’s latest capital market projections as of June 2015.

Against this backdrop, liquid alternatives hold out the prospect of alternative sources of return and portfolio diversification, which has in part fueled their growth.

Liquid Alternatives

Fund launches and assets under management (AUM) on the rise

The current investment environment has made liquid alternatives one of the fastest-growing categories in the investment world. Since 2008, the number of funds in the U.S. has tripled to more than 700, and AUM has quintupled to $500 billion with the number of firms managing these funds reaching nearly 300iii. However, the proliferation of strategies presents its own challenges. Researching liquid alternative strategies can sometimes raise more questions than answers for investors, including the basic question, “What is a liquid alternative?” Additionally, short track records and broad flexibility of many liquid alternative strategies make it difficult to understand underlying risk and return characteristics, complicating portfolio construction.

Liquid Alternatives

Defining liquid alternatives

Amid the multitude of strategies, defining liquid alternatives precisely isn’t simple. At PIMCO, we take a broad view: We define liquid alternatives as investments that exhibit modest to low correlation with traditional stock and bond investments and are accessible in broadly available investment vehicles that are without the principal lock-ups of traditional private equity funds and hedge funds . The term “liquid” therefore refers to the vehicle, not the underlying investment (which may or may not be liquid).

We further divide liquid alternatives into two major categories: alternative asset classes and alternative investment strategies. In both cases these investments tend to exhibit modest to low correlations with traditional stocks and bonds, but alternative asset classes and alternative investment strategies can be effective diversifiers for distinctly different reasons.

Alternative asset classes, such as commodities and emerging market currencies, provide exposure to alternative risk premia whose returns are driven by different economic drivers than traditional portfolios. Alternative investment strategies, on the other hand, are typically actively managed and not constrained by traditional benchmarks. These strategies may provide diversification through the manager’s individual security selection (or active management alpha), with much less reliance on broad stock and bond exposures to deliver returns. Examples of alternative strategies include absolute return fixed income, equity long/short and managed futures (see Figure 4).

Liquid Alternatives

Liquid alternatives: Portfolio considerations

Understanding risk characteristics

The varied risk characteristics of liquid alternatives – which reflect an array of asset classes, strategies and manager styles – can complicate the process of incorporating them into portfolios. Long/short equity managers, for instance, typically have a positive equity beta (they are normally net long equities), whereas equity market-neutral strategies target zero equity beta. Other categories, such as managed futures, may have more dynamic equity beta; equity beta may be positive in strong bull markets and negative during sustained market sell-offs. Implementing liquid alternatives in portfolios, therefore, requires understanding not only the different categories of strategies but, perhaps more importantly, comprehending how their key risk characteristics vary across different market environments.

In many ways, it is easier to grasp the risk profile of alternative asset classes, such as real estate investment trusts (REITs), commodities and currencies, since investment products in these categories often share similar benchmarks. While the benchmarks themselves often represent nontraditional sources of risk, investors have a better understanding of the risks they are taking.

However, there is a much greater challenge across most alternative investment strategy categories, as risks can vary dramatically even within the same category. Many of these strategies are often benchmarked to cash or LIBOR, providing little anchor for the risks in the underlying strategies. For example, a review of the top 10 managers by AUM in the nontraditional bond category reveals significant differences in total volatility and the risk contributions from credit and duration (see Figure 5). Multiple factors can

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