Liquid alternatives are among the investments that can expand your investment universe and potentially provide several benefits to your portfolio. Here’s what you need to know about liquid alternative investments.
What are liquid alternatives?
For investors, liquidity refers to how frequently you are able to buy or sell a particular investment. Alternative investments are offered with varying levels of liquidity.
For example, there are illiquid investments, like private equity or private credit, where your money can be tied up for a relatively long period of time. There are also liquid investments, like bitcoin, that can be easily bought and sold daily.
Among those that are more liquid, there are liquid alternative funds that have the structure of traditional mutual funds and ETFs, but they use strategies that are more sophisticated—like the ability to take long and short positions, use derivatives (a financial instrument whose value is based on an underlying asset, index, or commodity), and deploy leverage.
The liquid alternative advantage
Liquid alternative investments generally seek to generate returns that are less correlated to traditional investments, which means that these investments could behave differently than stocks, bonds, and cash across different market cycles.
Liquid alternative funds primarily invest in public market investments such as stocks, bonds, commodities, currencies, or in derivatives. Unlike traditional investments, the strategies for liquid alternative funds have the flexibility to take both long and short positions to potentially generate returns in up and down markets, diversify a portfolio, and manage risk.
Since liquid alternatives can be accessed through mutual funds and ETFs, they are generally priced daily, can be bought and sold at your discretion based on current market value, and offer straightforward tax reporting.
What you need to know about liquid alternatives
While liquid alternatives share many of the risks of other investments, there are additional risks to consider.
Investment risk. Like traditional investments, liquid alternative investments may be exposed to factors like economic risks and price volatility. However, these investments can be more speculative than many traditional mutual funds, since they often hold long and short positions, can use derivatives, and can deploy leverage.
Complexity. Some liquid alternatives utilize strategies that are more complex relative to traditional investments. This can include strategies using sophisticated investment techniques and products. It’s important to evaluate how they can appropriately fit within your investment mix.
Types of liquid alternative strategies
Liquid alternative strategies are offered through a variety of investment styles such as:
Long-short equity. Seeks to generate returns by taking long positions in stocks the fund expects to increase in value and short positions in stocks the fund expects to decrease in value.
Equity market neutral. Seeks to generate returns that minimize the impact of market direction by balancing long and short equity positions.
Equity hedged. Seeks to hedge downside risk or reduce volatility during periods of market weakness through the use of options and/or derivatives.
Macro trading. Uses analysis of the macroeconomic, political, and market environment to capitalize on predicted movements in financial markets.
Systematic trend. Pursues long-term growth by using quantitative models to identify and capitalize on market trends.
Event driven. Looks to exploit mispricing that can occur around corporate events such as mergers, acquisitions, bankruptcies, and earnings calls.
Defined outcome. Using options and/or derivatives, this strategy seeks to deliver defined investment outcomes that may place a cap on upside potential and attempt to buffer the impact of declining markets.
Multi-strategy. Employs a combination of different strategies that seek to manage risk and potentially enhance returns.
Derivative income. Offers investors a way to remain invested in the market while reshaping the risk/return profile of their equity allocations to incorporate complementary defensive or income-oriented features.
Are liquid alternatives right for you?
Long-term investors interested in achieving specific objectives and looking for ways to diversify a portfolio may find the case for liquid alternatives compelling. When exploring alternatives, it’s important to make sure that any investment aligns with your objectives, risk tolerance, and time horizon.