Today’s market conditions have forced investors to think outside the comfort zone of the [60:40] portfolio allocation.

Volatile equity markets and declining fixed income yields have turned the traditional [60:40] portfolio allocation between stocks and bonds on its head. According to one study, an investor would today need to allocate 83% to equity, 15% to real estate, and only 2% to bonds to earn a similar rate of return as a couple of decades ago. Unfortunately, such a high component of equity would push up the portfolio’s volatility and risk to unacceptable levels. Liquid alts can be the solution to this dilemma.

Something has to give, and its bonds

Quite obviously, the portfolio has to be rejigged with the introduction of new assets and/or new strategies that enhance risk-adjusted returns.

Realizing this, many institutional investors, particularly hedge funds and pensions, have assumed exposure to new assets such as real estate, commodities, and infrastructure. New strategies take advantage of short selling, leverage, and arbitrage using derivatives such as options and futures. Collectively, these are referred to as alternative investments.

A lot of these alternative investments are now housed inside of a mutual fund or ETF, ensuring daily liquidity for investors, particularly the retail variety. These funds are referred to as liquid alternatives.

Liquid alternatives can replace most or all of the bonds in the erstwhile [60:40] portfolio.

Note that the revamped portfolio may still feature stocks as the dominant component. However, a significant allocation to liquid alts can prove to be an excellent buffer during market downturns.

What, therefore, to expect

The upside of the portfolio may be capped, but the downside is also minimized.

It’s interesting to note that during the coronavirus meltdown in the markets, liquid alts did perform very much as expected, according to Claire Van Wyk-Allan, director of the Alternative Investment Management Association (AIMA).

“We’re incredibly pleased at how [liquid alts] have stood the test through this volatile period in Q1 and March, in particular, vastly outperforming their long-only index peers and benchmarks,” she said.

“We always look at the Scotiabank alternative mutual fund index. For the month of March, it drew down 6.61 percent versus the SMP TSX composite, which was down 17.74 percent.”

Advantage: liquid alternatives

Liquid alt products score over traditional alternatives in several ways:

• A lower minimum initial investment
• Lower management fees
• Easy trading in and out of the investment
• Regulatory supervision
• Regulatory caps on leverage and holdings of illiquid assets

On the flip side, liquid alternative funds are sophisticated and complex, and may not suit all investors. However, advisors can help investors select funds that meet their specific objectives.

Most commonly, these goals are portfolio diversification and enhanced risk-adjusted returns, particularly for long-duration, institutional investors such as pensions.

Liquid alternatives for advisors

According to an AIMA survey, advisors like to allocate 10% of clients’ portfolios to liquid alternatives. This may be too conservative, given that liquid alts have proved themselves in the pandemic-triggered meltdown. Besides, pension funds are known to push for as high a percentage of 50 percent for alternatives.

Advisors should bump up the allocation of liquid alts in their clients’ portfolios.

Related Story:  Innovator’s Defined Outcome ETFs – Prepare For Market Volatility