Liquid diversifiers: Why now?

Few would argue with the thesis that the market regime has changed markedly from the days of ultra-low interest rates, further fuelled 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 we witnessed the posterchild Nvidia lose a significant portion of its value in a single day in a five-sigma event,¹ 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.

Harnessing liquid and diversifying strategies in a volatile market

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.

Moreover, approaches such as relative-value strategies, which benefit from greater dispersion and market volatility, have the potential to perform well in this environment. Likewise, tail-risk hedging approaches, which acknowledge the shortcomings of traditional multi-asset diversifiers such as fixed-income market beta, may provide a more reliable form of protection in the context of a more skittish, volatile backdrop.

Collaboration for success

In summary, the opportunity set is rich. We think that both clients and asset managers need to adapt to the new normal and harness strategies that are liquid and diversifying, and which can pull their weight in less predictable market scenarios. This may require some investors to increase their appetite for complexity, sharpen their research (these are skill-based investments) and overcome biases from the previous decade. We anticipate that better performance from liquid alternative diversifiers over the last few years may help investors make the leap. 

Investors do not need to do it all on their own. If asset owners and asset managers partner together, we believe there is a greater likelihood that risks can be converted into opportunities, and establishing perspective on secular trends and themes can provide a roadmap for optimising future returns.

1 DeepSeek sparks AI stock selloff; Nvidia posts record market-cap loss, Reuters, 28 January 2025

Authors

Catherine Doyle

Investment specialist