A quick guide to liquid alternatives: diversified multi-strategy funds

In the ten years since the global financial crisis (GFC), equity markets have gone from the brink of collapse to historic highs. Direct central bank intervention in markets – widely known now as quantitative easing (QE) - was at the time of its introduction both unprecedented and controversial, but unarguably stabilised markets.

Indeed, the tailwind of very loose monetary policy as well as central bank asset purchases has been a major contributing factor in driving higher valuations for a range of risk assets. Equity market returns have been robust, with exceptionally low volatility. Bonds too, have enjoyed a lengthy bull market. However, we believe that we are now entering a new market phase in which traditional asset classes may struggle.

What is the new normal?

The US Federal Reserve (Fed) is already in the process of reducing the assets on its balance sheet acquired through QE. Central banks in the UK, Japan and eurozone are likely to move in the same direction in coming years.

As central banks back away from market support, we expect volatility to rise and returns at the index level to stagnate. We expect greater divergence in performance across asset classes and within markets, with greater focus on individual or idiosyncratic drivers. We expect equity and credit markets will put greater focus on corporate profitability.

Therefore, we expect the importance of alpha generation and diversification to rise. A diversified alternative strategy, such as a diversified multi-strategy fund, can offer the flexibility needed to isolate this alpha, while mitigating volatility. How?

Diversified multi-strategy funds

Alternatives generally seek to deliver positive returns over the longer-term, no matter what the stock market is doing, rather than trying to beat a particular index. These strategies seek to protect investments from market falls and offer genuine differentiation. Ultimately, they aim to provide diversification to portfolios. 

A diversified multi-strategy fund aims to reduce market “directionality”, through dynamically investing in a series of underlying sub funds, each using a different strategy. A combination of the below key strategies would not be uncommon.

What do they all mean?

• Long/short equity: This strategy typically takes long and short positions in equity and equity related securities where an increase, or respectively a decrease of the value of the position is expected. They may gain this exposure directly and/or indirectly through derivatives.
• Global macro: A global macro strategy makes investment decisions based on an assessment of the broad macro-economic environment. The approach is not restricted by asset class and may invest in assets such as equities, bonds, currencies, derivatives, and commodities. Typically, these funds invest indirectly through derivatives.
• Credit: Credit strategies seek to isolate one or all the specific risks related to credit instruments. The traditional credit risks traded are: default risk, the credit spread risk and the illiquidity risk. This strategy typically takes long and short positions in fixed and floating rate securities. They may gain this exposure directly and/or indirectly through derivatives. 
• Event driven: This strategy attempts to profit from price changes or mispricing of securities in anticipation of - or in response to - certain corporate actions. These may be bankruptcies, mergers and acquisitions, a restructuring, take-overs, an emergence from bankruptcy, shifts in corporate strategy, and other atypical events.
• Market neutral: Market neutral strategies attempt to reduce the systematic risk created by factors such as exposures to sectors, market-cap ranges, investment styles, currencies, and/or countries, by matching short positions against long positions within each area.
• Relative value: Funds following this strategy seek to take advantage of price differentials between related financial instruments, by simultaneously buying and selling the different securities with a view to making a profit from the “relative value” of the two.  

Why use a diversified multi-strategy fund?

Schroders’ Head of Liquid Alternatives, Andrew Dreaneen, believes diversified multi-strategy funds are likely to grow in popularity as the market environment becomes more challenging, and as investors seek smoother return profiles.

“As we move into the latter stages of the economic cycle - with expectations of increased volatility and dispersion between asset classes and individual names - a diversified approach that is able to express long and short positions becomes ever more important.

“We expect more and more clients to see this type of diversified multi-strategy fund as a core allocation in alternatives, and look to combine it with tactical allocations to niche strategies. This diversified approach, which focuses on alpha rather than market beta, aims to provide consistency of returns across a range of market conditions and deliver downside protection in more difficult periods for financial markets.”