The return of liquid alternatives

If liquid alternatives – the “forgotten asset class” – are to make a comeback amid market uncertainties, there will be a greater need for risk management, the European Investor Summit hears, writes Nik Pratt. 

Following years of neglect from asset allocators, liquid alternatives seem set to return to investors’ portfolios, thanks to the volatile market conditions of recent years. But if liquid alternatives are to reclaim their status as the ‘third’ asset class, between equities and fixed income, there needs to be a greater focus on risk management and investor education.

This was the view from a panel of alternative asset managers at the European Investor Summit held by Societe Generale Securities Services in Paris.

According to Meeraj Patel, Head of Sales at French quantitative manager ABC Arbitrage Asset Management, there has been an underappreciation of hedge funds and liquid alternatives. “It has been the forgotten asset class of the last ten years.”

In the relatively benign environment between 2015 and 2020, many liquid alternatives failed to outperform broad indices. But during the last two to three years in a market of volatility and dispersion, these types of strategies performed well and have been uncorrelated to the equities and bond markets, which has attracted investors, says Patel.

“Liquid alternatives managers like volatility and the current dislocated markets present short-term opportunities for us. It’s a high-octane, high-alpha environment and one that we are excited about,” says Patel.

Growth stages

The long-term picture for liquid alternatives has been one of growth, but when you interrogate that, there have been lots of different stages, says Georg Reutter, Partner and Head of Asset Management at Kepler Partners, the UK-based asset management boutique. The early 2010s saw a sharp rise in assets under management (AuM), followed by the ‘doldrums’ of the middle years. But in the last two to three years, there has been a pickup in AuM and the return of managers launching new products.

“It is very challenging to work out how you get consistent income and manage your downside risks, especially if we are in a recession that wipes out returns.”

Reutter puts this down to a recognition of the importance of diversification amid a ‘back to basics’ approach to investing. “Diversification matters even more so today,” says Reutter. “The effects of Covid and a high level of intervention from central banks have artificially held the markets up, and that has changed the perspective on diversification. In the past decade, investors looked to liquid alternatives as a replacement for fixed income at a time when interest rates were zero. But that has changed, and now you can expect a return from fixed income.”

The change in market conditions and improved performance mean that liquid alternatives should be viewed as a legitimate ‘third’ asset class that sits between, and complements, both equities and fixed income, said Reutter. “In terms of our fund research, we are trying to push allocators towards these funds that would have been seen as riskier a few years ago but now, put in the right context, can be viewed as lower risk, as they are good diversifiers, and can go into that middle ground between equities and fixed income. It means you can look at managers with a higher return profile that could take advantage of the current opportunities in the equities space – for example, market-neutral or arbitrage strategies where you can aim for double-digit returns,” said Reutter.

Regime change

In the last three years, says Bernadette Busquere, European Head of Hedge Fund Research at Amundi Asset Management, liquid alternatives have performed much better despite a huge regime change which caused a lot of pain for multi-asset and absolute return funds. The risk diversification and decorrelation benefits of liquid alternatives are more evident, capturing the high volatility that needs to be sustained.

“There will also be benefits from high-interest rates because of how liquid alternative funds are constructed,” says Busquere. “We have seen a lot of success among multi-asset, systematic, global macro and relative value managers. It is a different type of environment for hedge funds with higher-for-longer inflation levels, but it is still a dislocated market in terms of liquidity and lots of opportunities for alpha.”

“Liquid alternatives managers like volatility and the current dislocated markets present short-term opportunities for us. It’s a high-octane, high-alpha environment.”

Despite the optimism, there are concerns that need to be managed, agreed the panellists, be that geopolitical instability or difficult access to retail investors. And what is required is a greater focus on risk management and an investor awareness campaign, according to Andrew Gibson, CEO of UK-based International Asset Management.

In fact, there are parallels that can be drawn with the private assets market, where there is a focus on downside controls, diversification and access to top talent. The only difference is that private markets typically have less volatility and a longer duration to work out some of these concerns.

“It is very challenging to work out how you get consistent income and manage your downside risks, especially if we are in a recession that wipes out returns,” said Gibson. “We have to be patient, and we have to educate. One has to be as forward-looking as possible because the risks are growing, and you can manage those risks in the liquid space through proper active management.”

© 2023 funds europe

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