It has been a long time coming, but liquid alternative investment products are finally living up to their billing as shelters in the storm of market downturns.
According to Morningstar Inc., the bear market category has topped the alternative investment funds chart with year-to-date returns of 15.15 percent, as of January 15. That was followed by the managed futures category, which was up 3.77 percent.
Meanwhile, during that time the Barclays U.S. Aggregate Bond index had registered a gain of 0.97 percent, while the S&P 500 index had dropped nearly 8 percent, the MSCI World index was off 8.5 percent and the Russell 2000 had plunged 11.25 percent.
Liquid alts, or ’40 Act alternative mutual funds and, to a lesser degree, exchange-traded funds, became the rage after the last financial crisis as financial advisors and retail investors saw how well some alternative strategies––particularly managed futures and bear market funds––performed in the face of the global meltdown that hammered most asset classes.
“Alternative investments,” a catchall phrase encompassing a host of different investment strategies, aim to provide a smoother ride over different investment cycles by diversifying portfolios with assets that aren’t correlated to traditional long-only stocks and bonds. In theory, infusing portfolios with different revenue streams can help mitigate drawdowns in bear markets while providing some upside potential across various market conditions.
Problem is, growing investor demand for liquid alts—and the eagerness among financial companies to crank out products to meet and/or encourage demand—came after the financial crisis had passed and U.S. equities were off on one of history’s longest bull markets.
Many investors who added liquid alts to their portfolios were disappointed—in part because they compared the total return performance of these products versus equities. That’s like comparing kumquats and pomegranates, in that liquid alts aren’t built to outperform equities during bull markets. Rather, they’re portfolio diversification tools meant to provide a degree of non-correlation to stocks and bonds over a full market cycle.
Bear market funds, which employ strategies that are net short equities, are an obvious beneficiary of what so far in January has been the worst start to a year for U.S. equities ever.
Managed futures funds, on the other hand, typically employ trend-following strategies employing systematic, rules-based models that seek to take advantage of discernible investment trends––either up or down––in whatever assets they’re following.
That’s worked well in years marked by sustainable market trends, such as 2008. But global markets in the years since the crash have risen and fallen in a choppy, risk-on/risk-off environment marked by a high correlation among asset classes. That means fewer long-running, independent trends that trend-following managed futures strategies can depend on.