Is now the time to diversify portfolios with liquid alternatives?

Key takeaways

1. Liquid alternative strategies can offer returns that are differentiated from traditional equities and fixed income.
2. Liquid alternatives are attractive in markets where inflationary pressure and policy rate hikes from the Federal Reserve are significant risks.
3. Target Allocation model portfolios have recently utilized liquid alternatives to strengthen portfolio ballasts.

The traditional stock-bond portfolio has long relied on fixed income to play a stabilizing role. In many historical drawdowns, bonds helped cushion equity market weakness as yields fell and prices rose. However, that relationship has become less reliable in a regime shaped by higher inflation, policy uncertainty, and more frequent supply shocks. In 2022, the post-COVID inflationary shock hit a fever pitch. Financial conditions tightened across the board, leading stocks, credit, and Treasury bonds to sell off. Rather than serving as an effective ballast against market stress, bonds were challenged by the environment.

Ahead of that period, our team had already developed Target Allocation with Alternatives model portfolios. These models aim to introduce differentiated return streams by funding a liquid alternatives (liquid alts) allocation from fixed income. This year the Target Allocation team also added liquid alts to our flagship model portfolio family, Target Allocation ETF. We believe that even in models without a dedicated alts sleeve, a modest allocation to liquid alts can offer useful defensive characteristics. We similarly funded these allocations from fixed income, with the objective of strengthening our ballast.

How do regimes affect a portfolio’s ballast?

Multi-asset portfolios often rely on equities for growth and fixed income as a return cushion – but the shock absorption property of that cushion fades when stock-bond return correlations rise. Both asset classes moving in tandem weakens the defensiveness of fixed income.

This year reminded investors of that risk. Stocks sold off in the wake of the 2026 energy shock. In fixed income, the Treasury yield curve experienced a bear flattening as investors quickly priced in the potential for near-term rate hikes. While the lower volatility of bonds compared to stocks led to relatively smaller losses in more conservative, bond-heavy (rather than stock-heavy) portfolios during the equity market sell-off, we failed to see a positive return from bonds. That distinction matters. Bonds still play an important role in portfolios, particularly given today’s income potential, but their defensive characteristics can weaken when inflation risk is the source of market stress.

Positive correlation between stocks and bonds could make liquid alts attractive in the current environment. Headline inflation is heating up, and markets are pricing in a more hawkish Fed. Although our team does not foresee large rate hikes on the horizon or view another significant drawdown as imminent, we note that fixed income is not acting as an uncorrelated ballast. Liquid alts may, like in 2022, offer a stabilizing hedge.

What are liquid alts?

Liquid alt funds prioritize liquidity and accessibility yet typically use trading strategies associated with hedge funds, such as long-short and global macro. Many of them have a cash, money-market-like performance benchmark and potentially hold short-duration bonds, but their differentiation comes from layering risk-taking strategies on top. The liquid alt funds we focus on use market-neutral, long-short, and macro timing strategies, typically trading individual equities, futures (equity, rate, and commodity), and currencies. Strategy flexibility, leverage, and the ability to trade different assets potentially allow these funds to generate returns that are uncorrelated to rate or equity beta: we focus on liquid alts that are designed to maintain a low correlation to stock market returns.

Conclusion

BlackRock model portfolios are built to seek return streams that are durable across a range of market environments, including more challenging ones. In the current regime, fixed income may have lost some defensiveness. Our team believes that small allocations to liquid alts, funded from fixed income, can improve overall risk-adjusted returns. Selecting and sizing skilled liquid alt strategies that balance out equity risk is an important part of how we are managing portfolios for the current environment.