This year has seen a massive resurgence in popularity for liquid alternatives, with strategies such as managed futures, volatility, long-short equity, and more raking in flows. Liquid alts have been one of the few asset classes to have largely performed well in a challenging environment for equities and bonds. Bobby Blue, senior manager research analyst at Morningstar, recently sat down with VettaFi to discuss the trend towards liquid alts that began last year and has continued strongly into this year.
Liquid alts are mutual funds, closed-end funds, and ETFs that invest in alternative investment strategies offering downside protection and diversification opportunities while providing daily liquidity which makes them accessible to all investors. Up until partway through last year, liquid alts struggled to gain traction with investors in a market that was tilted strongly towards equity and fixed income beta.
“I think from a performance perspective, it was a bit of a lost decade for a lot of these strategies, not just trend, but most other liquid alt strategies too; long-short equity, market neutral, merger arbitrage,” Blue explained.
The Rise of Crisis Alpha Strategies
“These strategies, when they’re working well, they’re diversifying away from equity and fixed income beta — and that was the story of the 2010s,” said Blue.
The financial crisis of 2008–2009 brought to the forefront the need for diversification and downside protection after decades of strong economic growth, equity performance, and bond market appreciation, according to a white paper written in 2014 by Ezra Zask, the president at the time of the Liquid Alternative Investments Company. With that realization came a boom in liquid alternative funds that lasted for several years before drying up in a challenging environment for these alternative strategies.
“Now that that sort of theme has broken down a little bit, you are seeing some of these strategies perform better in this new environment,” Blue said.
“Investors are seeing the diversification benefits that these strategies can add to a portfolio with nearly zero correlation to equity and fixed income markets for long periods of time and seeing that they can improve a portfolio’s risk-adjusted returns — in some cases the absolute level of returns — depending on how you’re allocating to them.”
Managed futures are a subset of liquid alternatives that have offered better returns than many other asset classes this year and are best known for their ability to generate crisis alpha, a term coined following the financial crisis by Kathryn Kaminski to describe the strategy’s ability to find pockets of performance and profit during market turmoil and dislocation. Managed futures don’t just perform during downturns, however. Because they are quantitative-driven models that seek to offer certain levels of return regardless of market movement, they are classified as absolute return strategies at Morningstar.
“An investor looking for some sort of uncorrelated return stream… we would probably steer them towards an allocation to an opportunistic strategy like a systematic trend or global macro that have the ability to benefit when markets are going up,” Blue explained.
“When markets are down, they tend to have the lowest correlations to broader equity and fixed income markets; they’re that absolute return sleeve that can have the potential to generate performance in good times and bad.”
Capturing Volatility Regime Changes
Investors can gain access to managed futures strategies through hedge funds, mutual funds, and ETFs, though Blue anticipates that ETFs will continue to gain more market share over time. The iMGP DBi Managed Futures Strategy ETF (DBMF) is a managed futures fund that seeks long-term capital appreciation by investing in some of the most liquid U.S.-based futures contracts in a strategy that seeks to replicate the performance of the 20 largest managed futures hedge funds.
“Any managed futures manager will tell you the same: The strategies are really geared to capture these sort of market regime shifts when you move from one volatility regime to another and there are new drivers,” explained Blue. “The reason for that is just the relative slowness of different market participants to pick up on these [trends] and the sort of agnosticism of managed futures managers to jump on those trends as soon as they start to develop.”
Much of the barriers to investing in managed futures and liquid alternatives have been in the inherently more complex nature of derivatives investing and the futures market. Managed futures take long and short positions within futures on a range of asset classes, including equities, currencies, commodities, and fixed income.
“The one thing that we’ve really been emphasizing is, this is a space where probably extra care is required, extra diligence is required. We really encourage investors to understand the product,” cautioned Blue. “You don’t need to know what it is inside and out — a lot of these quant systematic strategies are difficult to really fully grasp — but understand when it will perform well and when it will struggle.”
DBMF utilizes its own Dynamic Beta Engine, a propriety, quantitative model that attempts to determine how the largest CTA hedge funds are allocated so that the portfolio mimics the performance of the average of the 20 largest CTA hedge funds. By offering the hedge fund strategy in an ETF wrapper, DBMF can provide cost savings that preserve more of the return stream generated for investors.
DBMF takes long positions in derivatives with exposures to asset classes, sectors, or markets that are anticipated to grow in value and takes short positions in derivatives with exposures expected to fall in value. Under normal market conditions, the fund seeks to maintain volatility between 8%–10% annually.
“I think it’s safe to say that at some point over the next 40 years, or however long your investment time horizon is, we will see a period like this again, and that is probably why you allocated to these strategies in the first place,” Blue said. “So keep them in there, understand them, and really have a good understanding of the role they’re serving in your portfolio.”
For more news, information, and strategy, visit the Managed Futures Channel.