With returns from traditional asset classes lower and more volatile than those realized historically, investors are turning to alternative investment strategies to enhance diversification and the potential for alpha, or risk-adjusted returns.

“Increasing demand for alternatives from investors seeking attractive sources of future return and diversification is being driven by the low yield environment, relatively high equity valuations and recognition that we are in a new paradigm where traditional approaches alone may not be adequate,” said Sabrina Callin, managing director in the Newport Beach office at Pimco.

Callin, who oversees Pimco’s enhanced equity index and unconstrained bond suite of products, sees potential in markets where large financial institutions are stepping back, including the provision of residential credit, commercial credit and corporate lending, as well as in liquid, outcome-oriented fixed income and equity strategies such as absolute return, market-neutral and long/short.

“To capitalize on alternative opportunities, managers need broad and deep resources, while investors must understand risk exposures, both systemic and variable, and how they will likely correlate to dominant risks in their existing portfolios,” she said.

The current wave of allocating to liquid alternative strategies (alternative investment strategies that are offered in mutual funds, ETFs and closed-end funds), is driven by the need for returns.

“With interest rates at historic lows, investors are not able to generate the returns they need for their desired outcomes,” said Brian Haskin, CEO of Alternative Strategy Partners. “This has led to not only a search for yield, but also a search for asset classes that have a likelihood of delivering returns greater than those expected from fixed income investments. Many alternative strategies fit this profile.”

Los Angeles-based Alternative Strategy Partners works with financial advisors, family offices, trust banks and institutional investors to build diversified investment portfolios that use liquid alternatives.

Its focus is on liquid, registered alternative investment products. This includes investment strategies such as Long/Short Equity, Merger Arbitrage, Global Macro, Managed Futures, Commodities, Real Estate, Multi-Strategy and more.
“We focus on alternative strategies that are packaged in mutual funds, exchange traded products (ETFs and ETNs), closed-end funds and other registered investment vehicles,” said Haskin.

Liquid alternatives are best defined by breaking the term down into its component parts: liquid and alternative.

Liquid means that investors have the ability to transact in the fund (i.e. buy or sell the fund) on a daily basis through an organized marketplace. Alternative means an investment that provides a source of return differentiated from traditional, long-only equity and bond market exposure.

“Many funds may, on the surface, meet the definition of being a ‘liquid alternative’ investment. However, there are other factors that may limit the actual liquidity or investment approach,” Haskin said. “At Alternative Strategy Partners, we focus on understanding each individual product, from the liquidity of its underlying investment holdings to how it is likely to behave under various market conditions.”

Private fund offerings typically allow managers greater flexibility and a broader set of tools than public fund vehicles with daily liquidity that are more widely available like mutual funds and ETFs.

For example, certain alternative strategies may capitalize on valuable illiquidity premiums that would not be possible in a vehicle offering investors daily liquidity.

Still, there are an increasing variety of potentially attractive opportunities and strategies available in vehicles that offer investors daily liquidity and can serve as a valuable complement to private fund alternatives and traditional bond and equity strategies.

“These include a number of higher alpha potential, outcome-oriented approaches like absolute return fixed income, multi-asset strategies, market-neutral equity and long/short equity,” said Callin. “There are also currency, managed futures and bear-market strategies that can provide valuable diversification and flexibility within an overall portfolio. And there are commodity and other real asset strategies that capture attractive alternative sources of market risk.”

The risk that fixed income returns will be negative over the coming years should interest rates rise is driving further demand for alternative strategies that can replace fixed income investments in both institutional and individual portfolios, as is the need for liquidity.

“Many institutional investors experienced liquidity constraints in the alternative investment portfolios during the 2008 – 2009 financial crisis, even in products that had moderately high levels of perceived liquidity,” said Haskin. “As a result, many institutional investors have migrated part of their alternative allocation to liquid strategies, such as those found in mutual funds, ETFs and other registered investment products.”