Morningstar last fall took a big step forward to help educate advisors and their clients about liquid alternatives and the role these strategies can play within a diversified portfolio. The term “liquid alternative” has evolved into a catch-all phrase for the various funds that offer access to strategies typically intended to behave differently from equities and fixed income, which can help reduce correlation to those asset classes and mitigate the overall volatility of a portfolio. Alternative strategies used to be available only via hedge funds and other pools of capital requiring accreditation, but in the last 10 to 15 years these strategies have become increasingly available both in traditional mutual funds and ETFs.
Morningstar created a style box that tracks correlation of liquid alternative strategies to global equities, as well as volatility. This process aims to help advisors and investors better understand how different strategies can complement other holdings and potentially impact a diversified portfolio. For example, a long/short equity strategy may not reduce correlation as much as merger arbitrage, risk parity or even gold. While the precious metal may be inclined to register as more volatile compared to other alternative strategies, ETFs that invest in gold through different currency terms can help diversification and dampen volatility.
(Related: Morningstar’s 11 ETFs to Avoid in 8 Sectors)
In presenting its methodology, Morningstar emphasizes a focus on equity volatility and the heightened risk to investors. However, the potential for downside volatility in bond funds also poses a new scenario to most advisory clients. Morningstar also correctly points out that some liquid alternatives, such as long/short equity and certain hedge fund replicators, take on equity beta; but others, even including the aforementioned strategy types, as well as market neutral and absolute return strategies, utilize fixed income beta and offer the opportunity to seek insulation against rising rates.
If and when interest rates normalize, an opportunity for certain liquid alternatives strategies to serve as fixed income proxies could further emerge. Invesco PowerShares came to a similar conclusion nearly two years ago when it launched its “Goodbye 60/40. Hello 50/30/20” campaign, which indicated that an asset allocation of 50% equities, 30% fixed income and 20% liquid alternatives can serve as a replacement for the traditional 60/40 mix due to a more complicated investing landscape, particularly among fixed income.
Managing for Myopic Loss Aversion
The overall style of Morningstar's evaluation may be a new tool for advisors to learn, but expect more data servicers and research providers to implement more robust analyses of liquid alternatives, too. Advisory clients remain concerned about the downside, and depending on their investment horizon and risk tolerances, will want volatility managed to help lessen the potential for large declines in equity markets. Myopic loss aversion means that declines in market value cause a greater emotional response than actual gains on investment capital, as investors are most prone to emotional mistakes after substantial declines.
Myopic loss aversion also holds true in fixed income investing, especially when interest rates rise. In his list of annual surprises for 2017, Blackstone's Byron Wien listed that a rise in the 10-year U.S. Treasury yield will approach 4%. Hypothetically speaking, and with most of 2017 yet to play out, if his prediction turns out to be accurate, bond funds with intermediate and longer-term durations may be looking at double-digit losses, which would catch many clients off guard. It exemplifies a scenario where advisors earn their pay, and a proper understanding and implementation of liquid alternatives can make that task easier.
As always, conducting the necessary due diligence prior to allocating to a liquid alternative strategy, including its investment structure, remains paramount. The ability to fully view all underlying holdings of an ETF at any given time — especially for a non-traditional investment strategy — coupled with better overall operational efficiency can always make for smoother client conversations, too.
--- Read Investors Struggle to Choose the Right ETF on ThinkAdvisor.