Liquid alternatives in the low interest rate environment

The current environment of low interest rates pressures investors in regards to generating returns and managing portfolio risk. Fixed income products have lost much of their diversification effect and may now provide even negative returns. Moreover, institutional investors that rely on risk budgets should reduce their exposure to shares as volatility has increased. This raises the question of how to use the free liquidity.

Liquid alternative strategies are those that operate independently of a benchmark and aim to produce absolute, i.e. positive, returns from non-traditional asset classes with a large flexibility regarding their investment. In today’s world, these strategies are often wrapped in a UCITS layer. “Such products can help, to reduce the volatility of the portfolio and to generate returns, that have a low correlation to the traditional asset classes of shares and bonds,” says David Saunders, fund manager of the Franklin K2 Alternative Strategies Fund, in an interview with dasinvestment.com.

Liquid alternative strategies can generally create returns from risk premiums that come from three sources, explains Ulf Füllgraf, managing director and CIO of Alpha Centauri. First, they can be fundamental such as distress or default premiums; they can be behavioural such as momentum premiums or institutional resulting from investment banks hiding their exposure to structured products.

Using liquid alternatives, market risks can be eliminated nearly completely as the products are often realised using long/short strategies. They can increase the return of a portfolio compared to traditional equity and fixed income mixes. Moreover, the returns generated are uncorrelated to those traditional asset classes and are recovering fast after drawdowns, says Füllgraf.

On the other hand, liquid alternatives inherit risks due to their asymmetric payoff profiles. As premiums are generated using products including derivatives, short positions and leverage, they include long tail risks that cannot be measured and managed properly using common tools.

Allianz Global Investors estimates, that typical European institutional Investors can increase their portfolio’s returns by 0.1 to 0.3 percent. To achieve this increase, AGI advices investors to combine multiple alternative risk premiums, to pay attention to risk management and the reduction of drawdowns, as well as to choose an approach that is market neutral, i.e. equity and interest rate risk free.