The COVID-19 pandemic set off large dislocations in global financial markets in the first quarter of 2020. Though liquid alternative investments aim to deliver returns that are less correlated to market swings and thus provide diversification, the quarter still proved to be a tough test for the sector.
In our recent research paper, “Liquid Alternatives’ Pandemic Test,” we summarize how the market dislocation affected funds across Morningstar’s alternative categories.
Broadly speaking, European alternative funds regulated under UCITS were not spared: the median fund registered a 6% loss in the first quarter. Still, most were able to hold better than their equity or multi-asset counterparts, and around one in seven managed to end the quarter in positive territory.
The UCITS alternative universe has grown tremendously in the last decade and is more globalized than ever in terms of market participants. But it remains young and evolving—around half of the funds in existence today launched in or after 2016. As such, many strategies have a limited history and only few can claim a track record spanning a full market cycle.
Hence, we think the COVID-19 sell-off has offered important lessons about how these funds fare during down markets, which investors can use to better understand and navigate this diverse arena.
1. Liquid alternative investments are not created equal
Liquid alternative investments are multifaceted. Within this broad group, there are significant differences in terms of mandates, return drivers, and approach to risk—and these factors impact their ability to truly diversify a portfolio. This was illustrated by variations in performance in the first quarter of 2020.
Some types of strategies, such as trend following and market-neutral funds, protected capital typically fairly well, as these funds are structurally better designed to perform well in a bear market. But many other strategies were caught in the mayhem when risk appetite dried up. This highlights that investors cannot necessarily think of liquid alternative investments as one catchall group; instead they need to consider strategies individually.
2. Return dispersion calls for careful manager selection
Return dispersion varied significantly between categories.
Long-short credit and event-driven strategies exhibited relatively low levels of dispersion, as funds in these categories had common drivers acting as a drag on performance. For instance, many long-short credit managers were hit by widening credit spreads in the high-yield and emerging-markets debt sectors; and event-driven strategies were caught by widening deal spreads (the difference between the current share price of a company being acquired and the offer price of a merger or acquisition bid) in March.
However, other areas experienced much more dramatic dispersion. Funds within the global macro Morningstar Category had an extremely wide range of outcomes, reflecting more pronounced differences in funds’ processes and positioning. As such, strong managers are often what make the difference for these funds’ return dispersion.
3. Both strategy and tactic impact performance
Unconstrained or absolute-return funds represent the most popular group in the arena of liquid alternative investments. Managers in this crowded sector may follow vastly different investment philosophies—and the recent market shock revealed or even magnified these differences.
Some managers with plenty of flexibility have been able to use this leeway to protect their portfolios. But managers of funds that rely more heavily on strategic asset allocation or apply fully systematic strategies have been faring poorly in the turbulence.
Though quick tactical adjustments may have helped some managers navigate this volatile environment, long-term investors should pay more attention to the quality and repeatability of a fund’s investment process rather than fixate on short-term results.