Introduction to Liquid Alternatives

Key takeaways

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

• Liquid alternatives often bring hedge fund–like investment approaches into daily liquid vehicles, expanding access to differentiated sources of return.
• They extend the investment toolkit beyond traditional long-only stock and bond portfolios, using techniques like long/short investing to seek lower correlation to broad market indices.
• By relying less on broad market direction, liquid alternatives can complement existing portfolio allocations and enhance diversification and risk-adjusted return potential.
• Successful implementation depends on prioritizing strategies that have demonstrated true diversification benefits, consistent performance, and alignment with client portfolio objectives.

What are liquid alternatives?

Liquid alternatives employ investment approaches commonly found in hedge funds, delivered through more accessible, often daily liquid vehicles such as mutual funds and exchange traded funds (ETFs). They invest primarily in publicly listed securities, distinguishing them from alternatives that focus on private markets.

Interest in liquid alternatives accelerated following the 2008 Global Financial Crisis, which reinforced the importance of transparency, liquidity, and risk management. It also brought greater focus to the role of differentiated, lower correlation sources of return, which were historically available primarily through institutional hedge fund structures. In the years that have followed, managers have increasingly brought these strategies commonly available in hedge funds into more widely available structures, expanding access to a broader range of investors.

In portfolios, liquid alternatives are typically used to enhance diversification and improve risk-adjusted return potential. By targeting differentiated sources of return that are less reliant on broad market direction, they can exhibit low correlations to traditional stocks, bonds, and even other alternatives.

How do liquid alternatives work?

Liquid alternatives rely on a broader investment toolkit than traditional stock and bond strategies.

One common approach used across many liquid alternatives is the ability to take both long and short positions. Managers can invest long in securities they expect to outperform (relative leaders) while also establishing short positions in those expected to underperform (relative laggards). This flexibility expands the opportunity set and enables returns to be driven by identifying relative performance differences, while reducing reliance on broad market direction, sometimes referred to as beta.

These differences in relative performance, or the gaps between leaders and laggards within and across markets, are known as dispersion. Market environments with heightened dispersion can present opportunities for relative value and active strategies to target return.

As shown in the chart below, dispersion has risen amid heightened macroeconomic and policy uncertainty. This increase is evident at both the micro level, where the spread between top- and bottom-performing stocks has widened, and at the macro level, where differences in country equity market returns have increased as economic and policy paths have diverged. Elevated dispersion creates a more favorable environment for strategies that can take advantage of relative performance differences.

Exhibit 1: Dispersion has been rising within and across markets

Derivatives, like options, forwards, futures and swaps, are another investment tool often used in liquid alternatives, enabling managers to express investment views across asset classes such as equities, interest rates, credit, currencies, and commodities.

Because derivatives allow exposure to be established using only a portion of invested capital, they can also provide a capital-efficient way to gain market exposure. Remaining assets are often invested in short-term instruments such as Treasury bills. As a result, fund performance may reflect the return generated from active positioning plus the yield generated on short-term cash. While derivatives can enhance flexibility and efficiency in expressing investment views, they also introduce additional risks, which we address later in this paper.

What are the different types of liquid alternatives?

Liquid alternatives encompass a wide range of strategy types that target different market dynamics and return drivers, including:

1. Long/short equity: Seeks to generate returns through stock selection while maintaining some net long market exposure.
2. Equity market neutral: Employs long/short stock selection strategies structured to keep market exposure close to zero.
3. Global macro: Seeks to capture relative value and directional opportunities across countries, asset classes, and industries.
4. Multi-strategy: Invests across multiple alternative strategies within one portfolio, combining complementary and diversifying return drivers.
5. Managed futures: Applies trend-following techniques to target returns during periods of persistent price trends.
6. Event-driven: Aims to monetize corporate actions such as mergers, acquisitions, and restructurings.
7. Relative value arbitrage: Seeks to exploit pricing inefficiencies between related securities while maintaining low net market exposure.
8. Digital assets: Provides exposure to blockchain-based assets and related strategies for differentiated performance relative to traditional markets.

These strategies can be used individually or combined within a diversified alternatives allocation. Because they access distinct opportunity sets, liquid alternatives may exhibit lower correlations to other portfolio allocations and to one another. With such a wide range of strategies and corresponding portfolio outcomes, it is critical that investors select funds that align to client investment objectives.

Where could liquid alternatives fit in portfolios?

Liquid alternatives are often used to strengthen diversification and seek to improve risk-adjusted outcomes within portfolios. This has become increasingly important for portfolio construction as the diversification historically associated with traditional stock-bond allocations has weakened amid rising equity concentration and a less consistent ballast from bonds.

As illustrated below, adding a dedicated allocation to liquid alternatives has the potential to reduce portfolio risk and enhance return outcomes across a range of risk profiles. In each case, the allocation is funded primarily from fixed income, with modest reductions to equities, reflecting a shift toward more diversified sources of return in conservative, moderate, and aggressive portfolios.

Exhibit 2: Liquid alternative allocations have the potential to improve portfolio results

What can wealth investors look for in a liquid alternative strategy?

Liquid alternatives span multiple strategy categories, and results can vary significantly even among strategies with similar mandates. When evaluating a liquid alternative, wealth investors should consider both its diversification potential and the consistency of its return profile over time.

Does the strategy meaningfully diversify your current portfolio? A useful starting point is examining how the strategy has historically behaved relative to major asset classes already held, such as equities, fixed income, or private markets.

One important characteristic to consider is the correlation to these exposures, as lower correlation may indicate a more differentiated return profile that complements the broader portfolio. It is also important to assess the strategy’s beta, or its sensitivity to broader market movements, with lower beta reflecting less sensitivity to market swings.

Both correlation and beta may vary depending on whether a strategy is designed to reduce or capture an element of directional exposure. The key is understanding how those exposures fit within the portfolio and ensuring they complement, rather than reinforce, existing risks.

Has the strategy provided durable, consistent returns over time? As a long-term allocation, a liquid alternative aims to generate returns across a range of market environments with relatively controlled volatility. Evaluating performance in both rising and declining markets can help assess the stability of the return profile.

Measures such as the Sharpe ratio, defined as the strategy’s excess return over a risk-free rate divided by the volatility of those returns, can help determine how efficiently a strategy has converted risk into return, with higher values indicating more efficient use of risk. Additionally, upside and downside capture ratios can provide insight into how the strategy has performed across different market environments. A strategy that captures a meaningful share of upside participation while limiting downside exposure may indicate that returns are driven by differentiated investment views rather than primarily by broad market exposure.

The chart below illustrates the range of returns and correlations across liquid alternative strategies, highlighting how outcomes can vary meaningfully even within similar categories. This reinforces the need to not just allocate to the category, but to select strategies that align with portfolio objectives and complement existing exposures.

Exhibit 3: Identifying liquid alternatives that can enhance portfolio resilience

What are the risks of liquid alternatives?

Liquid alternatives, like all investments, involve risk. Outcomes will vary depending on the strategy and may be influenced by market movements, short positions, and the use of derivatives. While liquid alternatives are often used to enhance diversification, they can still experience periods of loss, and diversification alone does not eliminate investment risk. Liquid alternatives span multiple strategy categories, and results can vary significantly even among strategies with similar mandates so thorough due diligence and thoughtful fund selection is critical.

Further, liquid alternative strategies that incorporate derivatives carry additional considerations and risks, including leverage and sensitivity to market movements. In certain cases, losses may exceed the initial investment, and liquidity of underlying instruments may vary depending on market conditions.