On the Hunt for Liquid Alternatives

Ten years ago, this firm - like many consultants - didn't even have a group that formally catered to this now increasingly prominent sector of the alternatives industry. With teams focusing on 'Hedge Funds' and 'Private Markets', bfinance's organisational structure perhaps represented what investors sought at the time; the subsequent reorientation of the 'Hedge Funds' team towards 'Diversifying Strategies' was emblematic of the subsequent shift in the attitudes after the financial crisis.

Better diversification, through the introduction of uncorrelated return streams as well as the reduction of equity factor risk exposure, has been high on the priority list for many investors, during a phase when traditional equity-bond rotation has proven increasingly unappealing.

Hedge funds have refined their mission since 2008, focusing on their diversification characteristics rather than the possibility of outsized returns. Even sub-sectors that traditionally had quite a significant equity beta, such as equity long/short, have in many cases placed greater emphasis on market neutrality or more moderated beta exposures.

But why, we might ask, have the past two years seen a strong emphasis on liquid alternatives such as alternative risk premia strategies, alternative-flavoured multi asset and liquid hedge fund strategies? For example, of the c. $3 billion in ‘Diversifying Strategies’ allocations upon which bfinance advised in the year to June 2017, 24% went into ‘alternative risk premia,’ versus zero in 2014 and 2015. Meanwhile, the 35% slice comprising, ‘hedge fund’ investments has leaned further towards liquid vehicles including UCITS structures, with all 2017 mandates from bfinance clients requiring monthly or better liquidity.

Certainly, the trend cannot be chalked up to a high-level reluctance to stomach illiquidity. During 2016-17, this firm’s ‘Private Markets’ team has witnessed record levels of advisory activity, reflecting the wider industry trend in favour of private debt, infrastructure, real estate and private equity charted by numerous commentators and researchers. The same applies to the issue of cost: although pressure on fees has been very strong, overall average fee expenditure has increased substantially among pension funds, due to greater use of non-traditional asset classes.

It is plausible that investors have been opting to use their increasing capacity for illiquid investment or higher spending on private debt, private equity, infrastructure and real estate, while illiquid hedge funds have not benefited to the same extent.

In the specific case of alternative risk premia (or “ARP”), greater product availability and greater industry awareness have certainly contributed towards making the sector more appealing to a wider investor base. The universe of providers of broad multi-premia multi-factor ARP strategies has expanded from approximately 30 at the start of 2016 to 50 in mid-2017, 25 of which are approaching or have passed the three-year mark in terms of live track record. Investors are increasingly aware of the capacity for these multi-asset, multi-premia, highly liquid strategies to provide effective diversification and returns without the “black boxes” traditionally associated with many diversifying strategies.

Another angle to be considered is the source of these mandates, from an asset allocation perspective. In many instances these are not coming from investors’ existing hedge fund portfolios, although this is the case for a minority of clients where overall fee reduction has been a point of consideration. The majority of ARP mandates, based on our own experience, appear to be funded by investors shifting away from long-only equity. In other words, they represent a renewed attempt in 2016-17 to reduce equity factor exposures. This could be a proactive risk move, or some form of profit-taking or rebalancing following what has been quite strong secular run in equity markets.

In addition, we should also consider the coincident shift in the ever-present quant ‘love/hate metacycle.’ Today we are certainly in a warmer part of that cycle, with investors more inclined to favour quantitative approaches than they were in – for instance – 2009-2013. There is a considerable overlap between quantitative alternative investment strategies and more liquid vehicles.

With these overarching trends at play, we expect liquid alternatives to remain firmly in the spotlight through 2017 and beyond. Over the longer term, the next significant market downturn may be critical in determining whether innovations such as ARP will earn a greater place in global institutional allocations.

Hedge funds have refined their mission since 2008, focusing on their diversification characteristics rather than the possibility of outsized returns.

Even sub-sectors that traditionally had quite a significant equity beta, such as equity long/short, have in many cases placed greater emphasis on market neutrality or more moderated beta exposures.

But why, we might ask, have the past two years seen a strong emphasis on liquid alternatives such as alternative risk premia strategies, alternative-flavoured multi asset and liquid hedge fund strategies? For example, of the c. $3 billion in ‘Diversifying Strategies’ allocations upon which bfinance advised in the year to June 2017, 24% went into ‘alternative risk premia,’ versus zero in 2014 and 2015. Meanwhile, the 35% slice comprising, ‘hedge fund’ investments has leaned further towards liquid vehicles including UCITS structures, with all 2017 mandates from bfinance clients requiring monthly or better liquidity.

Certainly, the trend cannot be chalked up to a high-level reluctance to stomach illiquidity. During 2016-17, this firm’s ‘Private Markets’ team has witnessed record levels of advisory activity, reflecting the wider industry trend in favour of private debt, infrastructure, real estate and private equity charted by numerous commentators and researchers. The same applies to the issue of cost: although pressure on fees has been very strong, overall average fee expenditure has increased substantially among pension funds, due to greater use of non-traditional asset classes.

It is plausible that investors have been opting to use their increasing capacity for illiquid investment or higher spending on private debt, private equity, infrastructure and real estate, while illiquid hedge funds have not benefited to the same extent.

In the specific case of alternative risk premia (or “ARP”), greater product availability and greater industry awareness have certainly contributed towards making the sector more appealing to a wider investor base. The universe of providers of broad multi-premia multi-factor ARP strategies has expanded from approximately 30 at the start of 2016 to 50 in mid-2017, 25 of which are approaching or have passed the three-year mark in terms of live track record. Investors are increasingly aware of the capacity for these multi-asset, multi-premia, highly liquid strategies to provide effective diversification and returns without the “black boxes” traditionally associated with many diversifying strategies.

Another angle to be considered is the source of these mandates, from an asset allocation perspective. In many instances these are not coming from investors’ existing hedge fund portfolios, although this is the case for a minority of clients where overall fee reduction has been a point of consideration. The majority of ARP mandates, based on our own experience, appear to be funded by investors shifting away from long-only equity. In other words, they represent a renewed attempt in 2016-17 to reduce equity factor exposures. This could be a proactive risk move, or some form of profit-taking or rebalancing following what has been quite strong secular run in equity markets.

In addition, we should also consider the coincident shift in the ever-present quant ‘love/hate metacycle.’ Today we are certainly in a warmer part of that cycle, with investors more inclined to favour quantitative approaches than they were in – for instance – 2009-2013. There is a considerable overlap between quantitative alternative investment strategies and more liquid vehicles.

With these overarching trends at play, we expect liquid alternatives to remain firmly in the spotlight through 2017 and beyond. Over the longer term, the next significant market downturn may be critical in determining whether innovations such as ARP will earn a greater place in global institutional allocations.