GSAM's Papagiannis: Liquid Alternatives For The Long Run

Apr 21 2017 | 8:44pm ET

Editor’s note: Interest in liquid alternatives cooled a bit last year amid a broad shift in investor perceptions around alternative investments in general and hedge funds in particular, but their core attraction – access to sophisticated investment strategies in liquid form and for low cost & minimums – remains relevant as scrutiny on hedge fund fees mounts. In this contributed article, Goldman Sachs Asset Management’s Nadia Papagiannis provides a review of the segment’s performance last year and her latest thinking on how liquid alternative investments can fit inside broader portfolios.

Alternative Strategies for the Long Run

By Nadia Papagiannis, Director of Alternative Investment Strategies, GSAM Global Third Party Distribution

Investment portfolios are intended to grow or preserve wealth for the future. But the performance of any given asset class in the short run can wax and wane. We think alternative strategies – either hedge funds or liquid alternative investments (LAI) depending on the investor's needs – can contribute to the sort of well-diversified portfolios that seek to help investors grow or preserve wealth for the long run.

In our view, liquid alternative investments (“LAI”) are daily liquid investment strategies that, like hedge funds, seek to deliver:

  • Differentiated returns from those of core asset classes - returns that are most beneficial during difficult times in core markets;
  • The potential to reduce overall portfolio risk; and
  • The potential to mitigate the effects of severe drawdowns, particularly in equities.

GSAM's Liquid Alternative Investments MAPS is designed to help investors better understand and allocate to liquid alternatives, or alternative mutual funds. In this analysis, we narrow down the vast universe of liquid alternatives to the funds that may better provide the differentiated return and risk characteristics of hedge funds.

We then categorize those funds into “LAI Peer Groups,” which align with the five major hedge fund categories: equity long/short, event driven, relative value, tactical trading/macro, and multistrategy. Investors can use these LAI Peer Groups to evaluate alternative mutual funds relative to other LAI and similar hedge fund strategies.

We think the second half of 2016 and especially the fourth quarter were apt demonstrations of one of the roles alternative strategies potentially can play: Performance during challenging periods for asset classes such as equities and fixed income. The second half of 2016 was a period of rising rates and political uncertainty. Between November 4 and December 16, the 10-year Treasury yield increased more than 80 basis points and the Bloomberg Barclays US Aggregate Bond Index fell 3.5%. During this same period, almost 80% of the funds in the LAI Multistrategy Peer Group – which aggregates diversified liquid alternative strategies offered as mutual funds – posted a gain, with a median rise of 1.3%.

We segment liquid alternative investment strategies into five distinct LAI Peer Groups based on strategy type in our LAI Market Analysis & Performance Summary (MAPS) publication. Four of the five LAI Peer Groups finished 2016 in positive territory, with only the Tactical Trading/Macro Peer Group down slightly (-0.7%). While alternatives underperformed equities last year, volatility for both the LAI Multistrategy Peer Group and HFRX Global Hedge Fund Index was significantly lower than equities and slightly higher than bonds.

Also notable was the number of LAI strategies that worked in the second half and especially Q4 of last year. For example, wide return dispersion among sectors and styles led to positive performance for the LAI Equity Long/Short and Relative Value Peer Groups (1.2% and 1.6%, respectively, in Q4). A positive deal-making and risk-taking environment was conducive for Event Driven strategies (1.0% in Q4). Further, within the LAI Tactical Trading/Macro Peer Group, global macro strategies were able to profit from currency trends, such as a rise in the US dollar. Relative to their respective hedge fund categories, the LAI Peer Groups performed similarly in 2016, with the exception of Event Driven.

Despite positive performance overall, liquid alternatives reported annual net outflows for the first time since 2000. Similarly, last year saw near-record hedge fund withdrawals and a number of fund closures, yet the hedge fund industry reached a record $3 trillion in assets under management due to positive performance in the second half of 2016. We would emphasize the importance of a long-term, strategic allocation to alternatives. Given muted return expectations for major asset classes in the coming years, we think now is a good time to take a fresh look at these strategies. 

Key Takeaways:

  • Most liquid alternative strategies posted gains in 2016, despite mixed performance in the first half and outflows throughout the year.
  • In the second half of 2016, liquid alternatives profited from many return sources in a challenging environment for bonds.
  • We believe a strategic allocation to liquid alternatives is critical to achieving long-term financial goals, particularly in a rising rate environment.

Goldman Sachs Asset Management is one of the largest and most experienced alternative investment managers in the world. The firm has 40 years of experience in alternative investing and manages more than $118 billion in alternative investment assets.

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