Navigating liquid alternative investment strategies

E*TRADE Securities

08/16/22

Summary: Learn about some common alternative-type investment strategies that may help investors diversify portfolios, manage risk, and enhance returns.

Liquid alternatives funds, commonly called liquid alts, were designed to offer exposure to 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 on a daily basis.

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. 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 designed 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 particularly valuable 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, we break down some common strategies.

Long-short equity

Long-short equity portfolios hold 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 take advantage of bull or bear markets.

Derivative income

Derivative income strategies incorporate options, typically through covered call writing, to generate income.

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

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

Multi-strategy portfolios employ a mix of investment strategies, at least two of which are alternative strategies that comprise 30%+ of the portfolio (although most expose a majority of funds to alternative strategies). Some funds may adjust their exposure to different strategies and asset classes.

Options trading

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 difference will narrow or close.

Macro trading

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

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.  

Commodities

While not exactly a strategy, commodity-focused funds can fall under the alternatives umbrella since they provide exposure to assets that don’t necessarily move in lockstep with stocks and bonds.

Broad-basket commodities funds invest in a diversified basket of 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 specific commodities sectors such as agriculture, energy, industrial metals, and precious metals.

Digital assets

Similarly, digital asset funds provide exposure to assets that utilize blockchain technology. These portfolios primarily invest in decentralized finance (DeFi) assets, stable coins, currency assets, smart contracts platforms, exchange assets, privacy assets, yield farming, and nonfungible tokens (NFTs).

Digital assets are often characterized by two risk factors: momentum and volatility, and funds can gain access to them through physical or derivative exposures and incorporate long-only investments as well as other hedging techniques.

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. 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.
  • 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. According to Morningstar's US fee study, investors paid an asset-weighted fee of 1.31% for alternative funds in 2019, double the 0.66% average cost of all US-based actively managed funds.1

Before you invest

Take time to read a fund’s prospectus and make sure you understand its investment objectives. For example, does it aim to diversify risk and preserve capital, or to generate income? How has the fund or the category of funds performed historically? What are the fees? And what might you expect in the case of a bull, bear, or volatile market?

Answers to these questions can help you determine whether liquid alternatives are suited for your goals, risk tolerance, and investment timeline.

 

  1. Morningstar, “2021 Global Liquid Alternatives Landscape,” July 2021

How can E*TRADE help?

All-Star funds

Choose from a list of leading exchange-traded funds or mutual funds selected by E*TRADE's investment strategy team.

Thematic Investing

Find ETFs that align with your values or with social, economic, and technology trends.

What to read next...

As investors explore ways to enhance returns and manage risk, liquid alternative funds have emerged as a potential choice. Learn what they are and what to consider before investing.

There's a diverse list of many different ETFs to choose from so here's a broad overview to get started. Read this article to learn more.

Leveraged and inverse exchange-traded products (ETPs) are considerably different than traditional exchange-traded products. They come with unique risks that investors should be aware of before incorporating them into their portfolios.

Looking to expand your financial knowledge?