Liquid alternatives for fixed income purport to deliver the best of both worlds: the trading edge of a hedge fund and the liquidity of a mutual fund. The trick lies in getting the ingredients right.

“The difficult balancing act for a ’40 Act mutual fund is being able to keep a liquid book, or keep enough liquidity in order to meet the potential redemptions that they’re going to see from investors,” said Jeffrey Gabrione, director of research at Lowery Asset Consulting. “They’ve got to be able to set a NAV, so they need to have a reasonable estimate of the valuation, and that’s going to keep them out of some of the less liquid positions that they might employ if they were running a hedge fund.”

Memories of 2008, when assets that were assumed to be liquid suddenly became illiquid, are still fresh in people’s minds. “In a mutual fund format you’re going to have to be extra cognizant of it,” said Gabrione. “My expectation is the investors are not going to want to put themselves in a situation where they can’t meet their clients’ redemption needs.”

More and more of Lowery’s clients are looking to non-traditional fixed income strategies in order to satisfy their desire for greater stability of principal than in the equities market, “but at the same time, they don’t want to get killed just because they’re standing in the way of a rising rate environment,” said Gabrione. “It’s a difficult juggling act.”

Liquid alternatives are hedge fund strategies that are available in a ‘40 Act mutual fund or a separate account for an institutional client.

“Liquid alternatives have been around for years but have been defined by what they’re not, i.e., stocks, bonds, or cash,” said Thomas Swaney, head of alternative fixed income, U.S., Pioneer Investments, in a webcast. “The good thing is that the market is now starting to differentiate along the spectrum of liquidity. Liquid alternatives are the same hedge fund strategies now available in an investment vehicle that has lower fees, greater transparency, and dealer liquidity.”

Diversification has long been a goal of asset allocation. Unfortunately, the allocation to long-only asset classes has not provided the level of diversification, particularly in times of stress, that clients expect, said Swaney.

“Unlike other strategies, liquid alternatives start with the premise of diversification,” he said. “These portfolios are constructed with multiple trading strategies that are designed to be uncorrelated with most market risks.”

A liquid alternative strategy should have Treasury bills or Libor as its benchmark. “You want to make sure that the benchmark doesn’t have any traditional market risk exposure embedded in it,” Swaney said.

Liquid alternatives should deliver higher risk-adjusted returns than long-only portfolios. Investors should consider factors such as the experience of the management team. “You want a management team that has built these portfolios from the bottom up, and has built these portfolios in both hedge funds and mutual funds,” said Swaney.

Another factor to consider is the quality of systems and processes to manage risk. Investing in leading risk management and portfolio construction tools and integrating them into the investment process is critical. “Investment technology is also important because managing trading strategies is very different than managing long-only portfolios,” Swaney said. “We need systems that can screen and evaluate thousands of potential trades across the world.”

Featured image via majcot/Dollar Photo Club