Alternative investments can be either liquid or illiquid. The more illiquid, longer-term positions tend to have higher return prospects – but also the liquidity costs that go with it. Examples of illiquid alternatives include private equity and real estate, which generally impose limits on withdrawals. Essentially, liquid alternatives can be more readily exchanged or sold than illiquids. They tend to have more of an absolute return focus – exploiting arbitrage opportunities or focusing on relative value strategies –seeking to generate returns irrespective of the overall direction of markets. There’s a diverse range of alternative strategies available across the risk-return spectrum. These strategies can employ a number of additional tools that can help improve diversification, risk management and potential returns. These strategies include:
This means investors in alternatives can really hone in on the strategy that best suits their portfolio from a risk, return and diversification perspective. The table below provides an overview of some of the most popular alternative strategies and the affiliated investment managers with expertise in that area.
Managed futures strategies typically focus on investing in listed bond, equity, commodity futures and currency markets, globally. Using future contracts, managers determine their positions based on expected profit potential. Market-neutral strategies look to profit from spreads and arbitrage created by mispricing. Trend-following strategies look to profit by going long (buying a holding) or short (borrowing a stock you don't own and selling it in the hope of repurchasing it at a lower price before returning to the stock lender) according to fundamentals or technical market signals. Systematic equity strategies, as the name suggests, use a suite of adaptive trading models that capture returns from trends within equity markets.
Global Macro strategies build portfolios around predictions of large-scale events on the individual country, region or global scale, implementing opportunistic investment strategies to capitalise on macroeconomic and geopolitical trends. They can take long (buying a holding) or short (borrowing a stock you don't own and selling it in the hope of repurchasing it at a lower price before returning to the stock lender) positions in multiple asset classes, with the ratio of holdings to each one based on their macro-economic projections. Portfolios are constructed at the asset-class level and can be based on a top-down view of global markets or they might use price-based and trend-following algorithms to help execute the fund's trades.
Long-short equity strategies invest in equities, as the name suggests, but they are considered alternatives as they seek to minimise market exposure while producing net gains. Long positions (essentially, buying a holding in a company stock) are those that are expected to increase in value. Short positions (borrowing a stock you don't own and selling it in the hope of repurchasing it at a lower price before returning to the stock lender) are those that are expected to decrease in value, which is sometimes referred to as ‘short selling’. These strategies can differ by geography, sector or investment philosophy and can have a broad or narrow scope.
Arbitrage & Absolute Return
Like other alternative investments, arbitrage and absolute return strategies include non-traditional assets and investment techniques. In essence, these strategies aim to deliver positive returns whatever the market does, rather than simply aiming to outperform a benchmark or reference index. Portfolios constructed using these strategies can be diversified across asset classes, geography and economic cycles, and managers pay special attention to the correlation between the different components of their portfolio.
Real estate strategies invest in funds that buy or sell properties, which can include commercial or retail properties, or real estate debt. Some strategies look to provide a return from capital appreciation and income over the longer term, and to deliver, over time, outperformance of a benchmark or reference index. Others seek to better align the benefits of property as a real asset with, for example, the liabilities of pension savers. As with other tangible or ‘real’ assets, real estate is considered an illiquid alternative. The Illiquidity premium means it has the potential for higher returns than more liquid assets. It can typically provide downside protection – as illiquid asset pricing typically lags behind public market asset pricing – and it can offer portfolio diversification. What’s more, there are predictable cash flows with real estate, which can be inflation-linked for the duration of long-term contract. However, the relative ease of valuation and ability to transact, as well as the potential difficulty in find buyers and sellers, are all factors that contribute to the asset’s illiquidity.
Private equity (PE) strategies can invest directly in private companies or participate in leveraged (debt-assisted) and management buy-outs of publicly listed companies. They can also co-invest or partner with other market participants to enable a private company, or portfolio of companies, to grow or transform. In contrast with publicly listed companies, which often have multiple shareholders, PE managers work alongside the private company’s management team to enhance the running of the business. This can involve all areas of operation, from the top-line growth, efficiency savings, cash generation and procurement, to supply-chains, marketing and sales, improving reporting and human resources. Investments will typically be in companies or portfolios of companies in the smaller to middle market size, as opposed to larger cap companies – or indeed early-stage businesses, which typically require seed money and venture capital to grow. PE firms will typically look to hold investments for between four and seven years, at which time they will look to sell, or ‘exit’, their stake, either on the stock market, to a corporate buyer or to another investor.
Private debt strategies invest in various types of loans and corporate bonds. Leveraged loans, for example, are one solution for institutional investors that allocated funds into government bonds more than a decade ago, when yields were attractive, and now wish to replace them as they mature. Other illiquid private debt strategies can also provide required yields and deliver a low risk, low volatility solution to long-term cashflow needs. These include investing in debt secured on real assets, like property and infrastructure.
Infrastructure strategies typically invest in ‘real assets’, like bridges, roads, airports and wind farms, but they can also invest in social development projects, which can include everything from hospitals to sustainable oceans. This can be through public private partnerships or core investments in regulated assets, through debt a variety of approaches within energy and utilities resources. As with other tangible or ‘real’ assets, infrastructure is considered an illiquid alternative. The Illiquidity premium means it has the potential for higher returns than more liquid assets. It can typically provide downside protection – as illiquid asset pricing typically lags behind public market asset pricing – and it can offer portfolio diversification. What’s more, there are predictable cash flows with infrastructure, which can be inflation-linked for the duration of long-term contract However, the relative ease of valuation and ability to transact, as well as the potential difficulty in find buyers and sellers, are all factors that contribute to the asset’s illiquidity.