There is almost total agreement that diversification is a powerful tool and that when properly utilized, can smooth returns and provide risk (drawdown) mitigation.  Even though the inclusion of alternative investments has been proven time and again to provide diversification benefits by providing differentiated sources of return while also reducing the volatility of an investment portfolio, many investors still do not allocate to alternatives. So why don’t more investors further diversify their portfolios outside of stocks and bonds?  We find that in most cases, it is because of a lack of knowledge and understanding surrounding alternative investments.

The inclusion of alternatives in a portfolio may not have enhanced the absolute return of a traditional 60/40 portfolio during the bull market that followed the 2008 Financial Crisis.  However, an allocation of up to 25% to alternatives would have improved a portfolio’s overall risk-return ratio even in this period of predominantly low volatility.¹  Given the more recent increased volatility in the equity markets and the uncertainty surrounding Fed Policy, now is a crucial time for investors to refocus on alternatives and how best to access them.  The great news is that alternatives are far more accessible now than pre-crisis thanks to the growth of Liquid Alternatives, i.e. mutual funds whose portfolio managers (or sub-advisers) employ strategies similar to that of hedge funds.

PIMCO’s recent white paper entitled “Liquid Alternatives: Considerations for Portfolio Implementation” is quite timely.  It provides investors a background on Liquid Alternatives, focusing on the evolution and return characteristics of the universe.  We thought it would be helpful to expand on their introduction and provide a layer of insight as to how we at Spouting Rock look at the universe, think about investment due diligence and ultimately proceed with fund/manager selection of Liquid Alternatives.  As experienced hedge fund and Liquid Alternatives investors, we hope that by providing additional insight to our due diligence framework it might aid the investor community in understanding the vast differences that exist between funds, leading to more informed allocation decisions.