Advisors Increasingly Turn to Liquid Alternatives Amid Market Volatility

Author: Montecito Capital Management, A Fee-Based Registered Investment Advisor (RIA) in Santa Barbara

New investment opportunities for protecting market loss downside have thus become more available in the retail investor marketplace. The last decade has seen the growing interest in “liquid alternatives” or “liquid alts” as a result of the inordinate interest in strategies associated with lower risk which has been fueled by soaring volatility and persistently low interest rates. Such alternative investments, between traditional mutual funds and complex hedge funds, have been able to offer sophisticated strategies combined with regulatory transparency and daily liquidity—advantages often lacking in the more complex of these funds.

Many a liquid alternative, the apex of which is a mutual fund or an ETF, combines strategies of the type followed by the hedge funds. Hedge funds, unlike liquid alternatives, are regulated and not thus offered to the public, ensuring daily trading in the shares, transparency of regular quotations, unvarying valuations of the security, and availability. This structure gives investors confidence, and reduces the exclusive application to institutions.

Structuring a portfolio around liquid alternatives is particularly attractive since classic asset-allocation schemes like the 60/40 stock-bond portfolio have recently been strained by the increasingly high correlation between stocks and bonds. A prime objective of liquid alternatives is absolute return, that is, a return that is positive regardless of the fluctuations of the market, which differs from the traditional asset classes, the value of which fluctuates according to market conditions.

Mutual and exchange-traded funds present the market with a clear, explicit price policy compared to the often opaque and higher prices charged by hedge funds. They offer the following advantages compared to the hedge funds: 

– greater diversification: in the shocks and co-movements of traditional asset classes, which liquid alternatives can decouple by giving access to strategies that are less correlated with stocks and bonds, diversification of sources of return and reduction of risks. 

– daily trade and liquidity: unlike the hedge funds which have large minimums and short redemptions, they allow the daily repositioning of assets and therefore offer agility and speed in hot markets. 

– Fee transparency: as ETFs or mutual funds, liquid alternatives have a clear and flat fee, which contrasts with the incognito and equivocal fees of many hedge funds.

Furthermore, market conditions in recent years, such as high volatility, muted growth and low yield on sovereign bonds, have led advisers to seek protection and profit with new devices. The prospect of increasing the real value of a liquid asset in a portfolio, for example, by adopting options strategies which thus permit a reduction in the value at risk without sacrificing participation in the increase in value, has led a large number of shareholders to increase their participation in it. As a result, some successful investors are now using the highest grade of money for this kind of purpose, because even for their managers it is a misfortune that with the agreement of many clients, they had at that time, as they formed the portfolios of others, the reins of a part of their portfolios and, as we now know, without following the current routs, invest in structures that offer a partial guarantee against any shock, or add a second dimension to their investments, like equities.

Across a number of asset classes, the broader diversification makes it possible to capitalize more dynamically and rapidly on opportunities to capture alpha. These strategies allow greater diversification and introduce additional risk/return profiles, which are not available from the old-fashioned assets.

Confidence in the monetary fluctuations of growth and the international economy are leading to an increasing appetite for defensive and diversified assets. The liquid alternatives market grows substantially; in 2024 the number of alternative funds has nearly doubled compared to 2020; by 2030 assets under management have tripled to $348.5 billion, and the trend is to grow to $4.1 trillion by 2030; the main cause is the resurgence of demand for this asset class from individual investors, improved investment regulation and a plethora of new fund structures that allow enhanced asset exploitation.

Many liquid alternatives, especially in Europe, have shown excellent risk-adjusted returns, with over 60% achieving Sharpe ratios greater than one in 2024, signifying proper risk management in relation to reward. Some carry higher costs than a traditional mutual fund, generally much less than a hedge fund, so it is important to carefully evaluate the cost-benefit relationship. During prolonged bull markets, liquid alternatives may underperform pure equity investments, sometimes by large margins; currency fluctuations, such as the depreciation of the dollar against other currencies, can affect global funds.

For investors and advisors, the focus is now on selecting the right type of liquid alternative, how to size their investment and how to diversify depending on individual goals, risk tolerance and market outlook. They offer a strategic balance between stocks and some fixed-income products and thus offer enhanced resilience by: – crisis diversification – a protective position when traditional markets falter – a dynamic attitude in changing economic and regulatory frameworks – a better exploitation of the potential of risk and return to achieve improved long-term performance.

This extended view combines data on market growth, diversification of strategies and practical considerations to give a clear picture of the future of liquid alternatives. As the portfolios grow more complex in the face of low yields and increased volatility, liquid alternatives are a valuable complement to them; a thoughtful addition, guided by the experience of advisors and aligned with the goals of each client, can improve the portfolio resiliency and provide investors with a favorable position in the rapidly evolving markets. The liquid alternative is therefore an essential element of modern portfolio management, as it has succeeded in blending transparency and illiquidity with the strategy sophistication of a type of funds; it thereby facilitates the diversification of risks, cushions the downside, and gives the potential of consistent positive results.