Building resilient portfolios: The role of liquid diversifiers

We have previously talked about a decade of disturbance and the scope for divergence in investment performance at a geographic, sector and asset-class level. This begs the question: is it possible to find strategies that offer not just attractive risk-adjusted returns, but also diversification within them? Furthermore, 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 minimise 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 recognise 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, 5 November 2024

Authors

Catherine Doyle

Investment specialist