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Why liquid alternatives can offer stability in turbulent markets

The uncorrelated performance of hedge funds and alternative investments need not be off limits to liquidity-conscious investors.

August 30, 2023

Yung-Shin Kung

Head & CIO, Quantitative Investment Strategies

Although we are heading into the second half of 2023 on a wave of positive returns, last year’s dismal market performance continues to reshape the way investors think about asset allocation.

2022 was one of the worst years in history for markets amidst a more volatile geopolitical situation, sustained inflation, aggressive interest rate hikes from central banks around the world, and persistent recession fears. It was a rare period when both bonds and equities plunged, along with most other asset classes.

The MSCI World stock index was down nearly 18%, while the Bloomberg Global Aggregate debt benchmark fell 13% – its biggest loss since it began in 1976. The average 60% equity/40% fixed income portfolio lost about 17% – the worst annual performance on record since the Great Depression.1

Hedge funds, which often trade across assets and across markets, outperformed public markets in 2022. Managed Futures and Global Macro were the two best performing hedge fund strategies, gaining 19.1% and 15.9% respectively, in 2022, while the industry, in aggregate, gained 1.1% according to the Credit Suisse Hedge Fund Index.2

This divergence has, not surprisingly, unleashed a surge of interest in alternative investments. Making or increasing an allocation to alternatives, however, is easier said than done. Many investors are unable or unwilling to accept the lack of liquidity common to private vehicles.

Investors wishing to gain exposure to the hedge fund industry can consider using liquid securities that track a diversified portfolio of alternative investments. In the right quantitative, rules-based framework, such strategies can replicate the performance of the hedge fund sector without the high entry requirements and lengthy lock-up periods that are typical of alternative investments.

More turbulence ahead?

Despite a strong first half of 2023 for most asset classes, we believe the case for diversification remains as strong as ever. Inflation in developed markets has moderated but remains well-above central bank targets, interest rates are still rising in various major economies, the threat of recession is looming, and geopolitical tensions remain elevated, most notably related to the Russia-Ukraine conflict and China-US relations.

Central banks thus face a trickier task than usual of trying to calm inflation while avoiding recession. In markets such as the UK and US, expectations had been widespread earlier in the year that a series of rapid rate hikes would quickly tame fast-rising prices. The impact of tightening has been more limited than expected – especially in the UK, where there is talk of rates climbing possibly as high as 7%.

The upshot is that global market turbulence is unlikely to ease any time soon.

In this uncertain environment, rules-based liquid alternative investments may offer a means of improving the portfolio risk-return characteristics. Such strategies have a low correlation to most other asset classes, and well-designed programs can adapt quickly to changing market conditions.

Quantitative Investments

Quantitative investment strategies provide portfolio diversification from mainstream equity and bond markets. Our strategies invest across alternative assets, managed futures and smart beta.

Range of features

Established liquid alternative funds often seek to provide broadly diversified exposure to the risk and return characteristics of hedge funds. To do so, they typically invest in equities and equity-type securities, fixed-income securities, cash and cash equivalents, currencies, and financial derivative instruments. Some even offer inverse exposure, which may be useful for hedging and risk management purposes.

Liquid alternatives also incorporate other features that may make them suitable for certain investors. Thanks to their diversified and tactical nature, they provide greater stability than most single asset class investments that aim to generate robust cumulative long-term returns. Diversification is a key component of their appeal: these solutions tend to avoid the larger concentration and counterparty risks that can come with an allocation to a single alternative asset manager.

A mathematical, rules-based approach contributes to stability and low market correlation by doing away with emotion and other behavioural biases. That can be a major benefit at times of geopolitical turmoil and tensions as well as heightened market stress.

Quantitative approaches offer methodological and exposure transparency, which can be particularly helpful to investors subject to various regulatory and reporting regimes. Additionally, their performance is typically measured against an industry benchmark, promoting expectation setting and unambiguously clarifying their “alpha.” These strategies can generally be tailored and optimised to suit different levels of risk tolerance and around different market regime expectations on an ongoing basis.

What’s more, liquid alternatives are flexible and scalable investments, given that they allocate across asset classes, geographies, and instrument types in public markets. Without lock-ups, they potentially allow investors to be more flexible in the size and speed of their allocations than is generally possible through private vehicles.

Liquid alternatives and quantitative strategies are far from new concepts. However, the past 18 months have proved that standard portfolio diversification is not always sufficient to protect investors against market dislocation. Hedge funds and other alternative investments have much to offer, and liquidity-focused investors need not miss out.

CSAM QIS’s LAB: Hassle-free hedge fund returns

Investors can synthetically access diversified hedge fund-like returns and risk profiles without having to allocate directly to such strategies.

The Quantitative Investment Strategies group of Credit Suisse Asset Management operates Liquid Alternative Beta, also known as LAB, a program providing hedge fund-like market exposure without the various liquidity challenges or higher fees that investing in hedge funds can bring.

LAB is a research-informed, rules-based investment program with a lengthy track record that dynamically allocates across a range of well-defined exposures in a highly transparent manner. It implements its objective utilizing three strategy category models – long/short equity, event driven and global strategies – and comprises equities and equity-type securities, fixed-income securities, cash and cash equivalent, currencies and financial derivative instruments.

However, LAB does not allocate to individual hedge fund managers and is principally implemented in a regulated fund. This makes the program accessible to most investors and ensures that investors are treated fairly and equally, both in terms of pricing and access. It offers daily liquidity, with no side pockets or gates.

LAB holds a highly diversified portfolio with no meaningful single issuer risk; investors in the program avoid the potential for headline or fraud risk that can be associated with single manager investments. The program offers diversification similar to that of a fund of funds, but without the multiple layers of fees.

Key points

Award-winning platform

LAB has received recognition for its performance in recent years in the form of several awards. It received prizes in the Refinitiv Lipper Fund Awards for Europe in 2021 and for Austria in 2023, in the alternative multi-asset strategies category.

This year LAB also came out on top in the Hedge Fund Journal’s 2023 UCITS Hedge Awards for best risk-adjusted returns over 3, 4, 5, 7 and 10 years in the Fund of Funds category. A fund implementing one of LAB’s component strategies, the Credit Suisse Managed Futures Strategy Fund, received The Hedge Fund Journal’s CTA and Discretionary Trader Award for best performing fund over 10 years in the CTA Beta category.

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