October 10, 2013

Liquid Alts, Pt. 2: Long-Short Bond and Macro Strategies

The first post in this blog series provided an overview of liquid alternatives strategies while providing a closer look at long-short equity strategies and event-driven strategies.  In this post we focus on long-short bond strategies and macro strategies, with concluding thoughts about selecting liquid alternative products.

Long-Short Bond Strategies

Long-short bond strategies include convertible arbitrage, relative value and distressed debt, and typically are used as bond substitutes in portfolio construction. Other long-short bond strategies may increase or decrease different risk factors, such as interest rate or credit risk, in order to produce a less correlated return pattern.

Convertible arbitrage strategies are similar to merger arbitrage, with funds typically buying convertible bonds while shorting the stocks of the same issuer. Conceptually, convertible arbitrage investors are seeking to capture the embedded option contained in the convertible structure while also benefiting from an illiquidity premium associated with the convertible.

Relative value strategies exploit price differences between various bonds and can offer steady returns with risk that is less correlated with bond markets. However, relative value strategies are also vulnerable to extreme market environments, and a strategy that is steady in good times can provide unexpected downside during events such as the Russia bond default in 1998 and the financial crisis of 2008. 

Distressed debt strategies invest in companies or government entities that are in default or are in distress and are headed for a likely default.  Investors often use distressedvdebt as an alternative investment, buying the debt at a deep discount while aiming for a high return if the company or country does not go bankrupt or there is a higher than expected recovery rate post-default.

We categorize distressed debt as a more volatile subset of the non-investment grade bond category. Distressed debt is less prominent among liquid alternatives than in the traditional alternatives landscape, as regulatory restrictions limit the ability of liquid alternative products to invest in what are typically concentrated and illiquid opportunities.

Macro Strategies

Currency strategies invest in currency futures, forwards or in short-term government debt.  Most of these strategies are short the U.S. dollar. Many of the strategies invest in higher-yielding currencies while shorting lower-yield currencies. Other strategies are trend following, using momentum to generate returns. The objective of currency funds is to provide bond-like returns and risk in a manner that’s uncorrelated with stock and bond markets.

Managed futures strategies make bets on a wide variety of futures contracts based on price momentum. These strategies are typically quantitative in nature and are designed to provide returns uncorrelated with equity markets. These portfolios are often diversified and include global exposures to currencies, commodities, equities and fixed income markets.  

Global macro strategies invest long and short in a wide variety of investments, including bonds, forwards, swaps and bonds in order to provide absolute returns with risks uncorrelated to stock and bond markets. A global macro strategy’s investment philosophy is often more nuanced and its process more qualitative when compared to a typical managed futures strategy that may follow a strictly mechanical trend-following process.

Macro strategies are typically used as bond substitutes due to their low volatility and low correlation to equities.

How to Select an Alt Strategy for Clients

When considering the process of selecting a liquid alternative, due diligence is critical, starting with research into the role that liquid alternatives would serve in the portfolio’s asset allocation. Examining past performance of the asset class is a foundational exercise—identifying the effectiveness with which the strategy will contribute to portfolio performance. 

For strategies that have a long-term record in private hedge fund form but a short track record in liquid form, it is critical to evaluate differences between structures that may limit the ability of the liquid vehicle to match the performance track record of the private vehicle. For example, arbitrage strategies that rely on leverage are constrained by leverage limitations placed on mutual funds and ETFs.

Similar constraints exist that may reduce the viability of strategies that focus on concentrated or illiquid positions, or which require extensive use of derivatives. Mutual fund-based alternative products face the additional challenge of needing to accommodate daily cash flows, a very different investment consideration than is faced by hedge funds and private equity funds that at best offer quarterly liquidity.

Given the short-track record of many 1940 Act-registered alternative products, advisors will need to evaluate the effectiveness of these products compared to their less-regulated family members. 

It’s also important to consider the context of the historical track record, understanding how changes in the investment environment may influence future performance of the strategy. Investments that did well during a 30-year environment of declining interest rates may not do as well in a low-interest-rate environment or an environment of rising rates. Trend-following investments may also not perform as well in an environment in which sudden and frequent reversals of trend are more the rule than the exception.  

In comparison with traditional investment strategies, many liquid alternative strategies feature significant performance differences between the best and worst performers in a category. This dispersion of results highlights the importance of due diligence.   

In categories such as event-driven and long-short bonds, the ranges are narrower.  This may be a function of the constraints placed on 1940 Act funds, which could create more similarity among the strategies.  Also, other strategies have shorter track records as 1940 Act funds and so are not visible in the table below

Click to enlargeWe are also wary of liquid alternatives managed by firms and managers that migrate from the long-only world to the world of alternatives. Short selling is a very different discipline in investment and implementation terms than long investing, and we prefer managers well versed in short selling.

In short, liquid alternatives provide an expanded opportunity set for advisors to use to improve client outcomes. However, advisors must also be aware of the potential pitfalls

View the first post in this blog series, and related articles on liquid alternatives.

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