AXS Insights
5 Steps to Enhance Your Stock, Bond and Cash Investments with Liquid Alternatives
Market volatility is on the minds of investors and financial advisors. We swung into 2020 on the heels of the longest running bull market in history, only to arrive at a screeching halt amid February’s market nosedive, representing the worst such slide since the 2008 financial crisis.
Amid such swings and continued market uncertainty given fears surrounding the unknown outcomes of the Coronavirus, the U.S. presidential election, US-China trade contention and other global geo-political events, investors and financial advisors alike seek solutions to help stabilize investment portfolios.
For equities, the 2009-2020 equity market bull run brought stock valuations to all-time highs, prompting market observers to evaluate how to handle the greater likelihood of an impending market correction. For fixed income, while the start of 2020 represented a climate expecting very little change in interest rates for the year, marked recent volatility is a sign that the Federal Reserve might, in fact, cut interest rates even further beyond their current historically low levels. And for cash, while often referred to as “king,” investors know that their money sitting on the sidelines could miss important participation in equity market upside.
Against that backdrop, how can investors enhance their stock, bond and cash investments? Many investors are turning to Liquid Alternatives. They have investment strategies available through retail-friendly structures, such as mutual funds, that provide daily liquidity, transparency, and the potential for equity market participation, downside protection, low volatility, and low correlation to traditional stock and bond investments.
Allocations to Liquid Alternatives can come from stock, bond or cash investments. Investors should employ a process for evaluating how best to fund their Liquid Alternatives to optimize their overall portfolio outcomes.
While there is no one-size-fits-all path to determining the best funding source for new and increased liquid alternative allocations, a 5-step framework that has withstood the test of time is the following:
- Establish investment objectives
- Identify strategies that support those objectives
- Examine investment options
- Establish the optimal size of the investment
- Determine the funding source for the allocation
Let’s explore these elements in more detail, as they collectively constitute an effective structure for identifying the most favorable sources of funding for liquid alternative allocations.
#1 Establish Investment Objectives
One of the most critical prerequisites to determining how best to incorporate liquid alternatives into your portfolio is to first establish the investments goals. Investments can be viewed merely as tools, instruments or ingredients to be combined within a portfolio to help realize an investor’s objectives. In this regard, alternative strategies are no different than equity or fixed-income strategies in terms of their larger purpose, albeit their many different characteristics and outcomes. Therefore, a clear understanding of an investor’s goals, is needed to identify which investments would most optimally achieve one’s investment objectives.
A few examples of investor objectives include:
- Growth – capital appreciation such that the price or value of the investment rises over time through equity market participation.
- Income – strategy to generate income from securities within the portfolio that boost yield and mitigate the impact of rising rates.
- Portfolio diversification – diversification can generate attractive, non-correlated returns while managing risk by combining a range of investments within a single portfolio. The basis for this approach is that a portfolio comprised of numerous types of investments can yield higher returns with less risk than a less diversified portfolio would. No amount of diversification or correlation can ensure profits or prevent losses.
- Principal protection – seeks to safeguard investment principal and generate positive returns without regard to changing market environments.
- Inflation hedging – an objective to protect against the potential diminished purchasing power of a currency based on rising prices in the relevant economy.
#2 Identify Strategies that Support the Investment Objectives
Among the most difficult tasks for investors and their financial advisors is to identify which strategies are best positioned to meet their investment objectives. If an investor seeks growth, for example, a strategy designed to result in capital appreciation might be appropriate. In contrast, if an investor is looking for absolute returns, a growth strategy would not be the best choice. This challenge of identifying strategies that support one’s investment objectives has become even more complicated in recent years, as scores of new investment products continue to flood the market, each with its own stated investment objective. As a result, careful scrutiny to align strategies with objectives is essential and will enable investors to identify the universe of securities to be further analyzed for portfolio inclusion.
#3 Examine Investment Options
Once a strategy universe has been identified that best meets an investor’s objectives, individual investments within that category need to be fully researched. Investors should understand a fund’s strategy, primary drivers of return, performance track record, expenses, portfolio management team expertise and other key characteristics. To facilitate fund-specific due diligence, investors considering liquid alternative funds should determine whether they are seeking single-manager exposure or multi-manager exposure. This decision might be based, in part, on the investment strategy. For example, if looking for a strategy like trend-following or event-driven, a single manager with deep expertise in that area could be an option, recognizing that single-manager funds inherently expose investors to single-manager risks. By contrast, a multi-manager fund would enable investors to avoid single-manager risk, while providing greater diversification within the single investment.
#4 Establish the Optimal Size of the Investment
Investors must determine how much to allocate to their liquid alternative investments. While the size of alternative allocations varies based on many factors, a range between 5% and 35% is not uncommon. Considerations that investors should apply in evaluating the size of a liquid alternative investment are the investor type (e.g., institutional vs. high net worth vs. retail), investment objectives, investor risk tolerance, the size of the overall portfolio, and the investor’s market outlook on both a short-term and long-term basis.
It is important to note, however, that if an investor determines that an allocation to alternatives is warranted, the investor should size the allocation sufficiently large enough to have an impact on the portfolio. Put another way, if the size of the investment is too minimal, the allocation will experience challenges in achieving its diversification and other objectives.
#5 Determine the Funding Source for the Allocation
It is only after the above actions are taken that an investor can most optimally determine how and from where funding of the allocation should occur to most robustly enhance portfolio outcomes. Specifically, as noted above, many objectives can be accomplished through the use of liquid alternatives, such as providing distinct sources of alpha,¹ reducing volatility, minimizing directional market risk, hedging against falling markets and generally augmenting portfolio diversification. It is only after the investor establishes objectives, identifies strategies to achieve those objectives, examines particular fund options, and establishes the optimal size of the investment that funding sources for the allocation should be considered.
As liquid alternatives sometimes are viewed as a distinct asset class, their incorporation into a portfolio should be viewed in concert with the traditional equity and fixed-income securities that also comprise the portfolio. The ways in which investors utilize liquid alts, and the sources used to fund those allocations, will be dependent, in part, on the roles in which the alternative strategies are desired to play alongside other investments.
While there are many factors that should weigh into the decision of how best to fund a new or expanded liquid alternatives allocation, the following are among the more common sources of funding:
Equities
Many investor objectives would support an allocation to liquid alternatives away from stocks and other equity securities within the portfolio. First, an allocation from equities to alternatives could help reduce the portfolio’s growth orientation in favor of one that has greater diversification benefits or downside risk mitigation potential. Second, if looking for an equity alternative, and if the liquid alt strategy has characteristics that are more in line with those of equities, a reduction in the portfolio’s equity allocation to fund the investment may be well warranted.
A more macro view might also suggest allocating from the equity portion of the portfolio when the investor’s market outlook suggests, for example, high equity valuations or when the equity markets are expected to come under stress. Some equity alternatives also can benefit from volatility by participation in rising equity markets while mitigating downside risk. Other alternatives, such as market neutral strategies, are designed to act independently of directional market moves and, therefore, could reduce overall risk while enabling the potential for returns.
In short, the equity portion of a portfolio can be an important and effective source of funding for new or increased allocations to liquid alternatives.
Fixed income
Alternatives also can be funded from a portfolio’s fixed-income bucket. Allocating from fixed-income securities can be effective particularly when the alternative investment possesses characteristics similar in some ways to fixed-income securities. Selected alternative investment strategies can be good substitutes for income-producing bond funds. For example, for investors seeking yield or concerned about the potential impact that rising rates could have on their bond holdings, fixed income alternatives can assist in managing drawdown risks, while still providing positive return potential.
Cash
Another common source of funding for new or increased allocations to liquid alternatives is cash. Investors may have cash on hand for many reasons and may even have intentionally stockpiled cash over concerns, such as a significant pending market event, overpriced stocks or unattractive fixed-income securities in low rate environments. Funding liquid alternatives with cash may augment diversification, particularly with strategies that are uncorrelated to traditional equity and fixed-income markets and utilize various asset classes that enhance portfolio diversification.
Multiple portfolio categories
One of the strategies employed to fund liquid alternatives among both institutional and retail investors is proportionate allocations from multiple portfolio categories. For example, during periods when both equities and fixed-income securities each possess limitations with respect to future outlook scenarios, investors may fund allocations proportionately away from stocks and bonds. This works well for both new and increased allocations to liquid alternatives. A 15% allocation to liquid alternatives could be funded, for example, from 5% allocations from each of equity, fixed-income and cash sources.
Blueprint for Determining How to Fund Liquid Alternative Allocations
As outlined above, having a clear blueprint as to why, when and how to fund allocations to liquid alternative investments will best position investors to maximize the impact of those investments and most successfully achieve their goals. Before determining how to fund new and increased liquid alt allocations, investors would benefit from developing and executing on a framework that results in the establishment of investment objectives, identification of strategies to achieve those objectives, examination of fund options, and determination of the optimal size of the investment.
There are numerous applications of liquid alternatives that each impact the considerations for how and where to source allocation funding. Three of the more common funding sources for liquid alternatives are current investor holdings of equities, fixed-income and cash. Depending on the several factors referenced above, many investors also determine that sourcing from multiple categories can best achieve their overall objectives.
No matter what the investor goals or size of a new or expanded liquid alternative allocation, investors will enhance their ability to best determine how and where the funding should come by applying a methodical framework to the analysis. In doing so, investors would not only better select optimal strategies and investments, but also potentially augment portfolio outcomes by funding those allocations from sources identified through the lens of the investor’s larger, more holistic set of objectives.
1) Alpha is the excess return of an investment relative to the return of a benchmark index.
This information is educational in nature and does not constitute investment advice. These views are subject to change at any time based on market and other conditions and no forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of any investment or trading intent. This content should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by AXS Investments or any third-party. You are solely responsible for determining whether any investment, investment strategy, security or related transaction is appropriate for you based on your personal investment objectives, financial circumstances and risk tolerance. AXS Investments does not provide tax or legal advice and the information herein should not be considered as such. AXS Investments disclaims any liability arising out of your use of the information contained herein. You should consult your legal or tax professional regarding your specific situation. All investing is subject to risk, including the possible loss of the money you invest. Alternative investments may not be suitable for all investors.
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