Liquid alternatives with a return objective targeting alpha (excess returns from idiosyncratic exposures) while at the same time limiting or eliminating market, beta, factor and directional exposures may help to balance overall portfolio risk exposures. These types of alternatives can be diversifying because their returns should be primarily driven by risk factors that aren’t closely related to economic and market conditions—and potentially even defensive in nature if their alphas tend to be strongest when economic risk is rising. These exposures can be accessed in a daily liquid mutual fund wrapper as liquid alternatives invest in tradeable securities, but deploy different investment strategies to provide diversification and defensive alpha.
The ability to target a diversifying and defensive return stream is especially important as macroeconomic uncertainty remains elevated. Why? The Fed’s commitment to defeating inflation means that policymakers are less likely to materially cut interest rates in the face of slowing growth. As a result, the degree of diversification that traditional bonds can offer in portfolios may be less reliable than in recent decades of below-target inflation. The defensive alpha in some diversifying liquid alternatives can offer an added source of ballast in portfolios for when risk assets with high economic exposure come under pressure.
Liquid alternatives can seek to take advantage of today’s macroeconomic and market dynamics to generate alpha from idiosyncratic risk while limiting market directional risks. This provides the “plus” in the “cash-plus” return targets of liquid alternatives. Security dispersion, or the difference in returns across individual securities, as well as macro dispersion, or the difference in returns across countries, regions, and instruments tends to rise during periods of market stress and volatility. Liquid alternatives that can take both long and short positions may thrive in these high dispersion environments because they can go long securities that may become outsized winners and go short securities that may become relative losers—targeting returns in the cross-section of markets with reduced dependence on market direction.
It’s important to note that liquid alternatives can vary widely and not all strategies are effective at playing the role of a diversifier. And like all investments, liquid alternatives come with inherent risks including potential losses and can be highly correlated with other asset classes like stocks and bonds. When identifying a liquid alternative to diversify portfolio exposures, investors may want to consider strategies that exhibit a low correlation to existing portfolio holdings and market beta factors such as overall stock and bond returns. Additionally, a history of consistent returns across a range of market environments, but especially during market downturns, may characterize defensive alpha strategies.
Seeking to enhance portfolio outcomes with alternatives
As a starting point for building an alternatives allocation, our colleagues in BlackRock’s US Wealth Advisory Market and Portfolio Insights team designed the portfolio highlighted in Figure 4, adding 12% to amplifiers (private equity and private debt) and 7% to diversifiers from a 60/40 portfolio. They found that over the last 5 years, adding alternatives improved portfolio returns by 1.5% while reducing overall portfolio risk by 0.3%—delivering the intended portfolio outcomes of seeking to amplify returns and diversify risk.
Figure 4: Setting your alternatives allocation
