Building Resilient Portfolios: The Role of Liquid Diversifiers

Few would argue with the thesis that the market regime has changed markedly from the days of ultra-low interest rates, further fueled by waves of quantitative easing that lifted all boats. The Covid-19 pandemic led to an increase in volatility, less price stability and inflation moving structurally higher. Moreover, the traditional negative correlation between bonds and equities has broken down over the last few years, creating a need to update the investment toolkit, diversifying away from equity and bond beta to create a more resilient return stream.

Today’s market backdrop presents a number of risks, many of which are structural in nature as a result of the end to the ‘easy money’ era, and there will be a need to have a keen awareness of considerations such as liquidity, valuation and concentration risks.

Navigating Risks and Opportunities in a Changing Global Landscape

Recent developments in artificial intelligence, where on a number of occasions in recent months we witnessed leading stocks lose a significant portion of their value, have placed the spotlight on idiosyncratic risk. The US equity market is highly concentrated, and this can cause havoc when elevated expectations start to unravel. However, it represents fertile ground for discerning investors as risk also represents opportunity.

The macroeconomic risk inherent in the backdrop challenges those structures and businesses unaccustomed to operating in a high-interest-rate environment. There is a need to distinguish the winners from the losers: more fragile companies are likely to struggle, while nimble, creditworthy entities should thrive. This applies across the asset-class spectrum, from equities to fixed income to alternatives, and managers need to possess skill to pick the correct drivers.

Another observable shift is the formation of spheres of influence in the world, evidenced by the geopolitical tensions which have become increasingly visible with tangible consequences, notably the outbreak of war in the Middle East and the Russia/Ukraine conflict. A changing world order will have major implications for capital and how we choose to invest. Indeed, it can be viewed as the reshaping of the capital system which, while daunting when viewed through one lens, can also be viewed as an opportunity for growth and innovation.

Optimizing Portfolios with Liquid and Diversifying Approaches

These forces should represent an environment in which strategies that are both liquid and diversifying can be invaluable. Rather than adopting a ‘buy and hold’ approach, we think there will be a need to be nimble and dynamic, using as wide a toolkit as possible to seek to capture diversified sources of alpha. Currency will also be an important factor; a weakening of the US dollar, for example, could have global repercussions and misalignment can create opportunities.

Rather than adopting a ‘buy and hold’ approach, we think there will be a need to be nimble and dynamic, using as wide a toolkit as possible to seek to capture diversified sources of alpha.

In this context, how should investors implement such strategies and what are the barriers they face?

One important consideration is that investors have the choice to adopt either a fully outsourced solution or a more modular approach where they can select the strategies that complement their existing needs. Positioning different strategies to distinguish between their functions within a total portfolio context can be helpful, with the key metric being what these exposures bring to the table. There is often an alphabet soup of names to navigate and a complexity hurdle to overcome, so providing a clear framework is key.

The hedge fund researchers at Bfinance have structured the liquid alternatives universe into three main buckets:¹

• The first of these includes convex/divergent approaches, such as tail-risk hedging strategies and diversified commodity trading advisor strategies. These have the potential to thrive in turbulent regimes and provide ‘heroic diversification.’
• The second bucket is comprised of market-independent strategies, such as equity market-neutral and relative-value systematic macro strategies. These can exhibit returns independent of the market environment, with an ability to generate uncorrelated return streams.
• Finally, the third bucket incorporates directional strategies such as equity long/short (with a long bias), dynamic beta or absolute-return strategies. These are more akin to traditional risk assets, seeking to deliver alpha through an unconstrained investment approach.

Distinct Approaches That Harness Manager Skill

Given the likelihood of persistent macroeconomic and geopolitical uncertainty leading to a greater dispersion of returns, we believe the current environment is likely to be positive for the introduction of carefully assembled strategies that are both liquid and diversifying, with each component exhibiting a distinct risk/return profile. The existence of manager skill is a prerequisite, as investors are unlikely to continue to be able to ride the wave of multi-decade, beta-driven rallies.

An example of a convex/divergent approach that should be suited to the new regime is tail-risk protection. This contains components to address both sharp and sustained drawdowns and can embed a funding element to minimize cost; indeed, the cost of such insurance is funded within the strategy itself. Investors can combine this approach with an equity allocation to help cushion the return stream in times of market turbulence.

In contrast, systematic strategies that are valued for their uncorrelated returns versus traditional assets have a different role to play. Their market-neutral design isolates alpha streams, derived from a range of sources including currency, equity, bonds and commodities, and works with the higher cash rate rather than fighting against it. It is also possible to blend systematic and discretionary approaches, each providing complementary return streams and with the potential for different time horizons.

Client-Centric Strategy Design

As with all successful strategy designs, there is no need for jargon-ridden labels: the focus should be on client needs and a structure that makes sense, given investment objectives, risk tolerance and other client-specific considerations. Education and understanding are paramount, and it is incumbent on the client, asset manager and/or adviser to work together in close partnership. Considering the utility of each component is also important and this will inform position sizing.

There is no need for jargon-ridden labels: the focus should be on client needs and a structure that makes sense, given investment objectives, risk tolerance and other client-specific considerations.

Finally, fees are another factor in the mix: many hedge-fund incumbents are currently price setters; however, new entrants are disrupting this space, and a pragmatic evaluation of net-of-fee returns and Sharpe ratios is critical in this evolving domain.

Resilient Portfolio Strategies

The ultimate aim for investors is to build a resilient portfolio, hence the need to establish clear classifications for strategies in this space in order to gain a fuller understanding of their utility from a total portfolio perspective. We encourage investors to consider this rapidly evolving domain with a fresh perspective. It is important to recognize that there is no ‘one-size-fits-all’ solution, and establishing a partnership with an asset manager that possesses the requisite expertise may be beneficial in achieving these objectives.

1 Forget Hedge Fund Strategy Labels – Here Are Three Groups that Matter, Bfinance, November 5, 2024

Authors

Catherine Doyle

Investment specialist