The prolonged global economic cycle is coming to an end and the very "unorthodox monetary policy" is coming to an end of central banks has led to low expected returns on traditional investments. Dominik Brunner of Schroders notes that investors are being pushed to increase their risk budget and invest in investment strategies that are sometimes unfamiliar and new to them.
"Pressure for higher risk-adjusted returns has investors increasingly looking for alternative investments", Dominik Brunner, Alternatives Director at Schroders Switzerland, says. In this asset class, Schroders includes hedge funds and private investments such as private equity, private debt, infrastructure and real estate, which are more complex and usually set up in illiquid form. Brunner sheds light on the liquidity aspect, showing how liquid and illiquid investments differ and the implications for asset allocation.
According to the report, liquid alternative investments are generally characterized by three main features:
– The different strategies are usually independent of benchmarks
– You aim for a total return (total return) or an absolute return (absolute return)
– To accomplish this in both rising and falling markets, fund managers can take both long and short positions.
As Brunner explains, these strategies also allow investors to take advantage of traditional alternative investment products in a more flexible way. Because they can typically buy or sell the fund shares daily, weekly or twice a month. In addition, investors enjoy all the benefits of the structure of a regulated mutual fund:
– much more transparency,
– the easier entry,
– the clearly regulated use of leverage products,
As well as fixed limits on the concentration of asset classes.
Advantages and disadvantages
Looking at the advantages over traditional, more illiquid products, the question is what are the disadvantages?. Many of the most successful hedge funds today are in liquid form (z.B. UCITS) available and their characteristics (z.B. Tracking error, performance pass, etc.) are comparable. Schroders' analysis shows that despite regulatory restrictions, liquid hedge funds are well able to provide investors with the benefits they seek (in particular, diversification, portfolio stability, reduced potential for loss).
Not every investment strategy is suitable for a liquid format, however, according to Schroders. Strategies like "Long Short Equity" or "Event Driven" are much easier to implement than strategies like "Macro" or "Relative Value.
In the discussion about the advantages and disadvantages of liquidity, the central question is, of course, whether investors are appropriately compensated for limited liquidity. "The liquidity premium is undisputed, although in practice it is difficult to quantify and can change over time", Brunner emphasizes. "In private markets, asymmetric information can help provide access to attractive investments, which in turn leads to higher returns." A UBS study on hedge funds shows that higher returns can be achieved with increasing illiquidity. "However, a clear statement about the current level of the liquidity premium is not very useful; rather, its existence over a longer time horizon should be used as a potential source of return", recommends Dominik Brunner.
In the context of asset allocation, the interplay between illiquid and liquid assets has interesting implications, he said. The use of liquid alternative investments could increase the scope for illiquid instruments, he said. In the context of a tactical allocation, liquid alternative investments could be used more flexibly (z. Ex. "risk-on vs. risk-off"). Brunner: "Liquid alternative investments can be seen as a very good complement to traditional investments, which can be very beneficial especially in a later phase of the economic cycle. Fundamentally, however, illiquidity makes it more difficult for investors to assess the potential risk-return profile of investments in an asset allocation."
Schroders does not recognize any superiority of illiquid over liquid alternative investments. "In a robust and complete asset allocation, the use of alternative investments seems to us unquestionable and, depending on the context and objective of the underlying asset allocation, liquid and illiquid alternative investments can ideally complement each other", Brunner concludes the comparison.