Since the financial crisis, investors have poured nearly half a trillion dollars into liquid alternative strategies – typically mutual funds and ETFs thatdeploy non-traditional strategies once reserved for large institutional investors.i These vehicles offer the potential for diversification,downside risk mitigation and attractive risk-adjusted returns with the transparency and daily liquidity many investors desire. Liquid alternatives havebeen a democratizing force for investors, and we believe today’s market environment arguably has only made them more attractive.

Yet implementing liquid alternatives in portfolios presents a complex set of challenges as risk, return and fee profiles vary widely across strategies. Inthe pages that follow, we present an overview of liquid alternative strategies and considerations for their implementation in portfolios.

Liquid alternatives: A search for returns and diversification
Typically packaged as mutual funds or ETFs, liquid alternatives bring many nontraditional investment strategies once reserved for large institutionalinvestors to a broader investor base. Assets in U.S. liquid alternative strategies have jumped from less than $100 billion in 2008 to more than $500billion at the end of 2014,ii with potential for continued growth ahead. Their popularity reflects the turbulence many investors endured withtraditional stock and bond portfolios in recent decades, as well as muted forward-looking return expectations for these asset classes.

The experiences of the past two decades left many investors searching for additional sources of return and diversification. They learned, often the hardway, that the majority of their portfolio’s return and risk had been driven by equities, an asset class prone to significant drawdowns. Although atraditional 60/40 portfolio has a 60% capital allocation to equities, risk is driven almost entirely by equities given that equities are much more volatilethan bonds. While this can lead to strong performance during equity bull markets, as has been the case in the U.S. since 2009, it can also leave portfoliosexposed to severe drawdowns (see Figure 1).

At the same time, unstable correlations across many assets have left investors with fewer reliable portfolio diversifiers. For example, the sharp increasein the correlation of stocks and bonds during 2013’s “Taper Tantrum” left many investors concerned about the ability of fixed income allocations todiversify their portfolio’s equity risk.

These significant market drawdowns over the past 15 years have resulted in much lower returns than investors experienced in the 1980s and 1990s. Duringthose decades, a traditional 60/40 portfolio had an average annualized return of 13.7% over rolling five-year periods. In contrast, since 2000, investorsreceived on average 5.9% and forward-looking expectations are even lower given today’s starting conditions (see Figure 2). As of 30 June 2015, 10-year U.S.Treasury yields of 2.4% were near historical lows, and in stocks, the S&P 500 dividend yield was 2.1% with cyclically-adjusted P/E ratios near all-timehighs. This stands in stark contrast to the conditions that preceded the strong bull market in stocks and bonds in the 1980s and 1990s, when10-yearTreasuries peaked near 16%, dividend yields approached 6% and cyclically-adjusted P/E ratios were near all-time lows. Today’s environment of lower yields,higher valuations and slower global growth has led to modest long-term return expectations for stocks of 4.5% and for core bonds of 2.5%, according toPIMCO’s latest capital market projections as of June 2015.

Against this backdrop, liquid alternatives hold out the prospect of alternative sources of return and portfolio diversification, which has in part fueledtheir growth.

Fund launches and assets under management (AUM) on the rise
The current investment environment has made liquid alternatives one of the fastest-growing categories in the investment world. Since 2008, the number of funds in the U.S. has tripled to more than 700, and AUM has quintupled to $500 billion with the number of firms managing these funds reaching nearly 300iii. However, the proliferation of strategies presents its own challenges. Researching liquid alternative strategies can sometimes raise more questions than answers for investors, including the basic question, “What is a liquid alternative?” Additionally, short track records and broad flexibility of many liquid alternative strategies make it difficult to understand underlying risk and return characteristics, complicating portfolio construction.

Defining liquid alternatives
Amid the multitude of strategies, defining liquid alternatives precisely isn’t simple. At PIMCO, we take a broad view: We define liquid alternatives asinvestments that exhibit modest to low correlation with traditional stock and bond investments and are accessible in broadly available investmentvehicles that are without the principal lock-ups of traditional private equity funds and hedge funds. The term “liquid” therefore refers to the vehicle, not the underlying investment (which may or may not be liquid).

We further divide liquid alternatives into two major categories: alternative asset classes and alternative investment strategies. In both cases these investments tend to exhibit modest to low correlations with traditional stocks andbonds, but alternative asset classes and alternative investment strategies can be effective diversifiers for distinctly different reasons.

Alternative asset classes, such as commodities and emerging market currencies, provide exposure to alternative risk premia whose returns are driven by different economic driversthan traditional portfolios. Alternative investment strategies, on the other hand, are typically actively managed and not constrained bytraditional benchmarks. These strategies may provide diversification through the manager’s individual security selection (or active management alpha), withmuch less reliance on broad stock and bond exposures to deliver returns. Examples of alternative strategies include absolute return fixed income, equitylong/short and managed futures (see Figure 4).

Liquid alternatives: Portfolio considerations
Understanding risk characteristics

The varied risk characteristics of liquid alternatives – which reflect an array of asset classes, strategies and manager styles – can complicate theprocess of incorporating them into portfolios. Long/short equity managers, for instance, typically have a positive equity beta (they are normally net longequities), whereas equity market-neutral strategies target zero equity beta. Other categories, such as managed futures, may have more dynamic equity beta;equity beta may be positive in strong bull markets and negative during sustained market sell-offs. Implementing liquid alternatives in portfolios,therefore, requires understanding not only the different categories of strategies but, perhaps more importantly, comprehending how their key riskcharacteristics vary across different market environments.

In many ways, it is easier to grasp the risk profile of alternative asset classes, such as real estate investment trusts (REITs), commodities andcurrencies, since investment products in these categories often share similar benchmarks. While the benchmarks themselves often represent nontraditionalsources of risk, investors have a better understanding of the risks they are taking.

However, there is a much greater challenge across most alternative investment strategy categories, as risks can vary dramatically even within the samecategory. Many of these strategies are often benchmarked to cash or LIBOR, providing little anchor for the risks in the underlying strategies. For example,a review of the top 10 managers by AUM in the nontraditional bond category reveals significant differences in total volatility and the risk contributionsfrom credit and duration (see Figure 5). Multiple factors can drive these discrepancies, including differences in investment processes, breadth ofopportunity set, investment outlook and product structure.

Alternative Asset Class Strategies

Bear market strategies are structured to provide attractive beta-hedging (or outright short) exposure.

Commodity and real estate-linked strategiesare tied to the performance of “real assets,” such as commodities and real estate.

Currency strategiesare designed to provide structural exposure to foreign currencies, in both developed and emerging markets, based on macroeconomic views and valuationanalyses.

Alternative Investment Strategies

Equity market-neutral strategiesseek to provide limited equity beta by taking equal long and short positions, thereby isolating the alpha component of an equity strategy.

Long/short equity strategies are designed to provide variable equity exposure while allowing for broader management of market risk and/or the ability to benefit from short exposurewith improved downside risk mitigation.

Multi-alternative strategiesseek attractive risk-adjusted returns with modest volatility and limited downside potential by allocating across a broad range of absolute-return-orientedstrategies.

Managed futures strategiesseek to generate positive returns by capturing price trends across major asset classes and have historically provided diversification to a traditionalportfolio of stocks and bonds, especially during times of market stress.

Nontraditional bond strategies seekpositive returns across all market environments by investing across global fixed income markets, often using a broad range of instruments; results areachieved through a combination of active management and trading expertise.

Therefore, we believe investors contemplating adding liquid alternatives to their portfolios should have a solid grasp of the following:

  • Total volatility and mix of risk, particularly correlations to traditional portfolio risks – equity risk and interest rate risk

  •  Historical drawdowns and drawdown potential and how they compare with expectations

  • Level and use of leverage and options to identify potential hidden risks

  • Performance across different market environments

Considerations for manager selection

Much as with traditional hedge fund and private equity fund investments, manager selection is crucial to the success of a liquid alternative investment. Asa manager’s discretion increases, so too does the potential for over (and under) performance. Figure 6 shows the range of outcomes by category over thefive years ending 30 June 2015. Not surprisingly, more traditional investments provided relatively consistent results across managers while alternativeinvestments had a much wider band. Whether offered as private or public strategies, many alternative strategies are inherently more dependent on portfoliomanager expertise – a larger component of returns may derive from active manager decisions, not market returns. However, given short track records acrossmany funds and the large number of options, manager selection can prove challenging. On the next page, we outline a suggested checklist for reviewing amanager’s potential to generate attractive risk-adjusted returns.

Fee variance
Fees, of course, are another important consideration, and they also vary widely across liquid alternative strategies. Part of this variance is driven by the structure of the investment product. For example, some managers aggregate third-party strategies, passing through underlying fees to end investors. In contrast, other structures that focus on individual securities may offer lower fees. When investing in alternatives, higher fees may be justified by the additional return potential offered – but not always. It is therefore important to evaluate a manager’s fee in relation to the value generated (see Figure 7).

Implementing liquid alternatives
Incorporating liquid alternative strategies in portfolios has the potential to expand the opportunity set and increase the chance of successful outcomes. Depending on an investor’s objectives and tolerance for risk, liquid alternative strategies can play a variety of roles in a portfolio and are commonly implemented in the following ways:

The Author

Justin Blesy

Asset Allocation Strategist

Ashish Tiwari

Head of Client Solutions, Americas


iPIMCO’s liquid alternative strategies are without the principal lock-ups of traditional private equity funds and hedge funds and include separateaccounts whose holdings can be liquidated at a client’s request subject to current market conditions, mutual funds that can be liquidated at NAV on a dailybasis and ETFs that can be liquidated on the secondary market under normal market conditions. There is no guarantee that a security will be able to beliquidated in a timely fashion or when it would be most advantageous to do so.

iiAs of 30 June 2015, Morningstar Direct. Based on Morningstar’s alternative mutual fund categories and assets under management.

iiiMorningstar data as of 30 June 2015.

Liquid alternatives are limited to certain investment vehicles organized in certain jurisdictions; not all investment vehicles may be available to allinvestors in all jurisdictions.

All investmentscontain risk and may lose value. Alternative investment strategies are often subject to greater risk than traditional investments.Diversification does not ensure against loss.

Risk Factor Modeling: PIMCO has historically used factor-based stress analyses that estimate portfolio return sensitivity to various risk factors. Essentially, portfolios aredecomposed into different risk factors and shocks are applied to those factors to estimate portfolio responses. Because of limitations of these modelingtechniques, we make no representation that use of these models will actually reflect future results, or that any investment actually will achieve resultssimilar to those shown. Hypothetical or simulated performance modeling techniques have inherent limitations. These techniques do not predict future actualperformance and are limited by assumptions that future market events will behave similarly to historical time periods or theoretical models. Future eventsvery often occur to causal relationships not anticipated by such models, and it should be expected that sharp differences will often occur between theresults of these models and actual investment results. Stress testing involves asset or portfolio modeling techniques that attempt to simulate possibleperformance outcomes using historical data and/or hypothetical performance modeling events. These methodologies can include, among other things, use ofhistorical data modeling, various factor or market change assumptions, different valuation models and subjective judgments.

Barclays U.S. Aggregate Index representssecurities that are SEC-registered taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index componentsfor government and corporate securities, mortgage pass-through securities and asset-backed securities. These major sectors are subdivided into morespecific indexes that are calculated and reported on a regular basis. The S&P 500 Index is an unmanaged market index generallyconsidered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible toinvest directly in an unmanaged index.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed forinformational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investmentproduct. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may bereproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY aretrademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the UnitedStates and throughout the world. ©2015, PIMCO.

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