Navigating liquid alternative investment strategies
E*TRADE from Morgan Stanley03/06/23
Summary: Learn about some common alternative-type investment strategies that may help investors diversify portfolios, manage risk, and enhance returns.
Liquid alternative funds, commonly called liquid alts, were designed to offer exposure to a version of hedge fund–style investment strategies in a more retail accessible, exchange-traded fund (ETF) or mutual fund format. These funds are regulated by the Investment Company Act of 1940 (’40 Act) and must adhere to certain liquidity requirements, meaning shares can be traded each day.
As a result, liquid alternatives should not be confused with alternative investments such as hedge funds. Mutual funds and ETFs are much more limited in the investments and strategies they are allowed to use, which means returns and portfolio characteristics of liquid alts may be materially different from those of alternative investments that have similar investment objectives or follow a similar strategy. Ultimately, the returns of liquid alts will generally be more closely correlated with traditional market returns than alternative investments will.
Still, liquid alts are different from traditional ETFs and mutual funds. Traditional ETFs and mutual funds typically use a “long-only” investment strategy, with the goal of matching or outperforming specific market benchmarks over time. Liquid alternative funds, on the other hand, employ a wide array of strategies intended to deliver returns or hedge risk regardless of broader market conditions, although no results are guaranteed. Additionally, some alternative funds track commodities such as metals, energy, or agricultural products, as well as digital assets.
Not all liquid alternatives work in the same way. Some use strategies that try to behave distinctly different from the markets. Others take on non-traditional risks to offer diversified sources of potential return. Still others attempt to benefit from rising and falling markets as opportunities arise. These strategies can be helpful during periods of heightened volatility and market downturns—although they come with unique risks to consider.
For investors interested in navigating the world of liquid alts, below we break down some common strategies, as defined by Morningstar. Please review the “Risks to consider,” as many of these categories rely on complex financial instruments and/or investment techniques that can make it difficult to understand a fund’s risks, as well as expose the fund to increased volatility and unanticipated risks.
Long-short equity portfolios generally take both long and short positions in equities, ETFs, and related derivatives. This means fund managers take long positions in securities and derivatives they expect to appreciate and short positions in securities and derivatives they expect to decline. They may also adjust their overall market exposure to try to take advantage of bull or bear markets.
Equity market neutral
Equity market neutral funds look to profit from long and short equity strategies, but they aim to take little to no market risk by offsetting long positions with matching short ones.
Event driven funds attempt to profit when security prices change in response to certain corporate actions, such as mergers and acquisitions, restructuring, and bankruptcy, for example.
Multi-strategy portfolios employ a mix of investment strategies, at least two of which are alternative-like strategies that comprise 30%+ of the portfolio (although most expose a majority of the portfolio to alternative-like strategies). Some funds may adjust their exposure to different strategies and asset classes.
Options trading strategies attempt to limit downside risk and market sensitivity. These funds use a variety of options trades, including put writing, options spreads, options-based hedged equity, and collar strategies, among others.
Relative value arbitrage
Relative value arbitrage funds attempt to take advantage of price discrepancies between pairs or combinations of securities, wagering that the price difference between them will eventually narrow or close.
Macro trading strategies look to capitalize on macroeconomic and political trends by taking long or short positions in equities, bonds, currencies, and commodities in various countries. For example, these funds may short stocks in countries they believe are headed into recession soon.
Systematic trend funds primarily implement trend-following, price-momentum strategies by trading long and short futures, options, swaps, and foreign exchange contracts. They typically diversify across a range of global markets, including commodities, currencies, government bonds, interest rates, and equity indexes.
While not exactly a strategy, commodity-focused funds can fall under the liquid alternatives umbrella since they provide exposure to assets that may not move in lockstep with stocks and bonds.
Broad-basket commodities funds invest in a diversified basket of securities that seek exposure to commodities such as grains, minerals, metals, livestock, cotton, oils, sugar, coffee, and cocoa. They may invest directly in physical assets or commodity-linked derivatives.
Focused commodities funds instead target exposure to specific commodities sectors such as agriculture, energy, industrial metals, and precious metals.
Digital asset funds provide exposure to digital assets through physical or derivative exposure, or by investing in securities of issuers that operate within the blockchain industry.
Risks to consider
While these alternative-style strategies may help investors diversify sources of potential risk and return, it’s important to understand they may ultimately lag or underperform the broad market. In addition to those discussed above, key risks to consider include:
- Liquidity. Liquid alternative funds are required by law to provide daily liquidity. However, during periods of extreme market stress, there have been instances where investors were not able to immediately redeem their shares. Liquid alternative ETFs are also more likely to trade at discounts to net asset value (NAV) due to the increased volatility and illiquidity often associated with their underlying investments.
- Complexity. These strategies can be complex, tapping into the most complicated financial instruments. It’s not always clear how funds may perform in different market environments and over various periods of time.
- Leverage. Leverage—borrowing capital to increase the value of a fund’s underlying portfolio—is a common feature in liquid alternative investment strategies. Often, funds use leverage in an attempt to amplify returns, but it can also result in outsized losses.
- Fees. High fees diminish investors’ returns and help explain the disappointing performance of some strategies.
Before you invest
Take time to read a fund’s prospectus and make sure you understand its investment objectives. The prospectus also includes a fund’s detailed risk disclosures and describes its charges and fees.
Learning more about a specific liquid alternative fund will help you determine if it’s suited for your goals, risk tolerance, and investment timeline.
How can E*TRADE from Morgan Stanley help?
Choose from a list of exchange-traded funds or mutual funds selected by Morgan Stanley Smith Barney LLC.