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  • Felix Narhi

New Ball, New Game: The Role Of Liquid Alternatives In Balanced Portfolios

In the cult classic film ‘The Big Lebowski,’ Jeff Bridges plays The Dude whose life is thrown into disarray when his beloved rug is damaged in a home invasion. As he tells his bowling pals, “That rug really tied the room together.” The famous line of dialogue has spawned a thousand t-shirts and probably a few rug sales, too. I’m no expert on home décor, but as a portfolio manager I can vouch for the benefits of utilizing differentiated investment strategies that really tie the portfolio together throughout various market cycles. One of those differentiated strategies is the use of liquid alternatives.

Over three years ago, Canadian regulators allowed hedge fund strategies to be available to retail investors through mutual funds and ETFs. These investments, called liquid alternatives, aim to provide diversification, non-correlated returns, and less volatility than the overall market. You can think of them as ‘hedge-fund-lite’ because they come with certain limits on the amount of leverage and shorting they can offer. Unlike traditional hedge funds, they do not lock up investors’ capital for a prolonged period, hence the modifier ‘liquid.’ Investors can trade in them exactly as they would any mutual fund or ETF. Not surprisingly, liquid alternative funds have proven to be very popular. In Canada, there are over 160 mutual funds and over 130 ETFs representing over $20 billion in assets under management in this category.

‘New Game’

Fans of cricket may be familiar with the expression, ‘new ball, new game.’ At the beginning of each inning in a test match, each side is given a new ball, fresh from the box.

So what’s the ‘new game’ for investors? Here’s a sampler:

  • The regime change from ultra-low interest rates to a higher-for-longer scenario and, possibly, a central bank target greater than the historical two per cent

  • Growing geopolitical tensions, including between China and the West, and the economic effects of on-shoring manufacturing

  • Rising risk of business earnings compression

  • A shift in sentiment to TARA (there are reasonable alternatives) from TINA (there are no alternatives)

Liquid alternative strategies are the ‘new ball’ for a ‘new game.’ An investment strategy that works well during periods of low inflation, high valuations, and a risk-on mood may disappoint when the tide turns and inflation is rising rapidly and valuations shrink along with investors’ enthusiasm. Likewise, there are times, like 2022, when asset classes such as equities and bonds ‒ that normally have a low correlation to one another and can thus provide diversification benefits ‒ move as one.

The motto’ ‘Set it and forget it’ sounds snappy, but, unfortunately, it doesn’t make the grade in every market cycle. Hence, the growing investor appetite for liquid alternatives to provide real diversification.

Classic Version

There are different kinds of liquid alternative strategies. One classic version is the equity long-short that takes both positive and negative positions on listed shares. There is also risk arbitrage or merger arbitrage that seeks to generate profits during a merger and acquisition event or takeover deal. Another type involves differentiated credit strategies that employ hedges in fixed income investments to manage volatility and generate lower-risk returns.

A quality liquid alternative fund should not be highly correlated to the market, (what some call ‘beta in disguise’). It should also be expected to generate positive long-term returns.

Allocating a ‘sleeve,’ or a portion, of a portfolio’s total value to liquid alternatives can add diversification for a better risk-return balance over the long term.

Investment strategies that were previously only available to institutional investors, such as pension funds and to high-net-worth individuals, are now available to any investor who seeks positive real returns in uncertain times.

Felix Narhi is CIO and a portfolio manager at PenderFund.


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