Multi-Asset

Liquid alternatives: Opportunities and risks

Finding an asset with positive expected return and low correlation to existing investments can strengthen a long-term portfolio outcome.

September 2020

With global negative-yielding debt soaring above $15 trillion this summer, investors are looking beyond traditional asset classes and long-only strategies to generate return. Finding an asset with positive expected return and low correlation to existing investments can strengthen the long-term outcome of a portfolio, most notably by reducing volatility. While this can be a challenge in an increasingly interdependent and correlated world awash with massive liquidity hunting for yield, an expanding universe of liquid alternative strategies (liquid alts) has arisen to meet investor demand for new sources of return and diversification. In this edition of our mini-forum series, we discuss the opportunities and risks associated with these strategies.

The quest for diversification: Liquid alts opportunities

Liquid alts seek to deliver the risk and return characteristics of alternative investments, such as hedge funds, using highly liquid and mostly exchange-traded instruments, thereby allowing investors to benefit from nontraditional sources of returns. For example, investors can take short positions in stocks or bond duration in an effort to profit from falling equity markets or rising interest rates. Liquid alts include an array of investment styles with low to negative correlation to traditional investments across financial markets. This is what makes them attractive portfolio diversifiers.

Alternative risk premia in practice

Academic Premia

Carry: Positive expected return if everything stays the same; Buying high yielders, selling low yielders
Value: Buying cheap assets, selling expensive ones
Trend/Momentum: Long absolute positive performer, short absolute negative performers
Quality: Buying high quality assets, sell lower quality assets
Volatility: Implied versus realized; Selling insurance

Opportunistic/Trading Premia

Alternative Carry: Repo arbitrage, dividend arbitrage, liquidity premium
Alternative Value: Structural trading imbalances linked to flows
Trading Pattern: Higher frequency strategies

Hedging Strategies

Hedges: Linear pay offs using standard derivatives
Tall Risk Hedges: Convex pay offs using volatility derivatives

Source: Société Générale, BMO Global Asset Management

Academic premia are well-documented strategies supported by a vast academic literature. For the most part, they can be implemented and managed quite easily. They largely rely on a factor-based approach, which aims to harvest risk premia with low long-term correlations to equities or bonds. Opportunistic strategies typically involve a more complex implementation in terms of portfolio management and trading. For example, a high-turnover strategy designed to harvest intra-day patterns would require a more robust trading infrastructure. Finally, hedging strategies focus on return opportunities that exhibit a high degree of asymmetry and positive convexity when equity markets sell off. These strategies may also require a high degree of expertise and infrastructure, as the more complex and potentially profitable strategies are executed using options.

Equity volatility: Harvesting yield in a minefield

Investors have used option-based strategies to enhance portfolio yield for a long time. Examples include more conservative collar strategies and selling equity put options, which inherently embeds greater risks for investors. The volatility risk premium results from a greater number of buyers, who wish to purchase protection against downside risk, versus a more limited number of sellers of put options, who are willing to absorb the downside risk of equities. The equity volatility premium has been relatively stable over the past 20 years, as the demand for downside protection remains a persistent characteristic of the marketplace. However, when the volatility premium moves adversely against sellers, it can move fast and hard.

The following example illustrates the potential perils of a simple approach to this dynamic. An investor might aim to sell one-month VIX futures, but such sell-and-hold strategy comes with highly skewed downside moments. Meanwhile, investors who simply buy volatility every month to protect against downside risk can incur a slow but certain loss of capital, as the term structure of volatility is usually upward-sloping and offers a deep negative carry. Investors trading such strategies are jokingly known to be headed toward two equally unpleasant options: sudden death by a heart attack from selling volatility or slow but certain death by cancer from buying volatility.

Returns from selling one-month VIX futures to harvest volatility risk premium

Source: Bloomberg, BMO Global Asset Management, as of August 20, 2020. Past performance should not be seen as an indication of future performance.

Machine learning: A new hope

While risk-premia investing offers diversification for investors, generating low-correlated returns has remained elusive. Diversified risk-premia strategies have experienced periods of disappointing performance in recent years and suffered another blow during the COVID-19 storm without benefiting from the V-shaped rebound by stocks. Alternative asset managers focused on systematic equity strategies have had an even more prolonged period of pain, which can be partly attributed to the persistent underperformance of the value factor. However, some managers are adapting to this challenging market environment by increasingly relying on machine learning and big data to generate alpha. We think the ability to adapt and innovate in these ways will benefit investors in the future.

Multi-alternative risk premia

Source: Société Générale, Bloomberg, BMO Global Asset Management, as of August 20, 2020. Past performance should not be seen as an indication of future performance.

Tail-risk hedging: Magnifying returns when fear is unleashed

For fearful investors tortured by market-moving Trump tweets, the U.S.-China trade war and more recently by COVID-19, a popular strategy is to allocate to strategies designed to deliver maximum positive return (convexity) when equity markets sell off. Tail-risk hedging (TRH) strategies profit from market corrections, but they require a careful implementation, as the costs of buying downside protection can easily eat away at the profits obtained from riding the long-only portion of a portfolio. The use of TRH enables investors to better manage risk without simply taking risk off the table or trying to time markets, a path which too often means missing out on sudden bursts of positive equity performance.

The balanced fund of the future likely includes liquid alts

The secular trend of falling interest rates is approaching its limit as global rates have converged at the zero floor or fallen outright below it. 60/40 investors are increasingly likely to use liquid alts to help offset the loss of yield from the fixed-income portion of their balanced portfolio.

Implementation of liquid alts has been helped by the modernization of investment regulations in most jurisdictions. What was once accessible only to high-net-worth investors is slowly becoming available to retail investors, though high-leverage strategies will likely remain the exception.

The strategic and tactical opportunities within the liquid alts universe are vast. For a more traditional long-term investor, the best approach is probably a robust and diversified alternative sleeve designed to complement a core portfolio of stocks and bonds. Such a portfolio is likely to better weather the challenging market environments of the future.

Disclosures

This material is intended for institutional/professional investors, the investments and investment strategies discussed are not suitable for, or applicable to every individual. Investing in alternative investments presents the opportunity for significant losses, including the possible loss of your total investment. Such strategies have the potential for heightened volatility and in general, are not suitable for all investors.

This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This presentation may contain forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such statements, as actual results could differ materially due to various risks and uncertainties. This publication is prepared for general information only. This material does not constitute investment, tax or legal advice to any party and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

Foreign investing involves special risks due to factors such as increased volatility, currency fluctuation and political uncertainties. Investing in emerging markets can be riskier than investing in well-established foreign markets.

Past performance is not necessarily a guide to future performance. Asset allocation and diversification do not ensure a profit or guarantee against loss.

In the United States and Canada, BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide investment management and trust and custody services. Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations. BMO Financial Group is a service mark of Bank of Montreal (BMO).

BMO Asset Management Corp., BMO Private Bank, BMO Harris Bank N.A. and BMO Harris Financial Advisors, Inc. are affiliated companies. BMO Private Bank is a brand name used in the United States by BMO Harris Bank N.A. BMO Harris Financial Advisors, Inc. is a member FINRA/SIPC, an SEC registered investment adviser and offers advisory services and insurance products. Not all products and services are available in every state and/or location.

This financial promotion is issued for marketing and information purposes; in the United Kingdom by BMO Asset Management Limited, which is authorised and regulated by the Financial Conduct Authority; in the EU by BMO Asset Management Netherlands B.V., which is regulated by the Dutch Authority for the Financial Markets (AFM); and in Switzerland by BMO Global Asset Management (Swiss) GmbH acting as representative offices of BMO Asset Management Limited in Switzerland, which are authorised by FINMA.

Securities, investment advisory and insurance products are: NOT A DEPOSIT — NOT FDIC INSURED — NOT BANK GUARANTEED — MAY LOSE VALUE.

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Liquid alternatives: Opportunities and risks

Subscribe to our insights

The quest for diversification: Liquid alts opportunities

Alternative risk premia in practice

Equity volatility: Harvesting yield in a minefield

Returns from selling one-month VIX futures to harvest volatility risk premium

Machine learning: A new hope

Multi-alternative risk premia

Tail-risk hedging: Magnifying returns when fear is unleashed

The balanced fund of the future likely includes liquid alts

Disclosures

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