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November 17, 2020 | GSAM Connect

Helping Navigate Daily Liquid Alternatives: Steer Clear of These Potholes

Three common pitfalls to avoid

With daily liquid alternatives (DLAs) being an alternative to traditional asset classes, naturally there may be less familiarity in how to appropriately allocate to them. Therefore, when we occasionally hear of investor disappointment with alternatives, we at GSAM often find that it stems from poor implementation choices within portfolios, rather than inherent flaws with the strategies themselves. Using the Coronacrisis equity market drawdown during early 2020 as a case study, we uncovered 3 common implementation pitfalls that we believe you should consider avoiding.

1. Casting too wide with the term ‘alternative’

We believe the problem starts with confusion around what exactly is a daily liquid alternative. In our view, DLAs provide characteristics similar to hedge funds in an attempt to differentiate returns from equities and fixed income, reduce portfolio risk, and manage the impact of equity drawdowns. While Morningstar is commonly viewed as the industry guidepost for fund classification, over half of the funds belonging to the alternatives categories do not meet the narrower criteria of our ‘GSAM DLA Peer Groups.’ During the Coronacrisis drawdown, the Morningstar funds that we exclude from our definition exhibited sharp performance disparity—with nearly a quarter having deeper drawdowns than the S&P 500 (-34%). We can help sift through the complex fund landscape to identify funds that we believe are more likely to provide investors with the risk and return characteristics of hedge-fund-like strategies.

EXHIBIT 1: Narrower criteria are needed to filter out more equity sensitive funds

Source: GSAM and Morningstar. This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. We note that investing in alternative investments, either through hedge funds or mutual funds, involves potential risks and investors can lose money. Alternative investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. Liquid alternatives are funds seeking to offer the characteristics of hedge funds, but with the daily liquidity of a mutual fund. Please see our detailed risk disclosures included in the end notes and link below.

Relevant Morningstar categories include categories that Morningstar, Inc. categorized as liquid alternatives and Nontraditional Bond category as of as of December 31, 2019. Sources of information used in this process include but are not limited to fund prospectuses, fact sheets, semi-annual/annual shareholder reports, manager commentary, and performance data. Full methodology is found in our annual “Daily Liquid Alternatives Group Alignment and Performance Summary (GAPS)” found here:

2. Excessive Strategy Concentration

We find that many investors tend to lack strategy diversification when implementing alternatives. Among the variety of DLA strategies (such as Equity Long/Short, Tactical Trading, Relative Value, and Event Driven) the most used is Equity Long/Short. However, these funds have historically had the highest beta to equities,1 and therefore may disappoint exactly when investors hope to realize the potential benefits of alternatives. During the Coronacrisis drawdown, the median Equity Long/Short fund fell -22%, double that of all other alternative funds. Instead of attempting to pinpoint specific strategies, we believe that implementing a multi-strategy approach – using funds that provide broad exposure across a variety of strategies – can potentially improve the consistency of outcomes and reduce investor disappointment.

Exhibit 2. Single strategy funds tend to experience less predictable outcomes

Source: GSAM and Morningstar. ‘Coronacrisis’ period reflects the drawdown period of the S&P 500 Index from 2/20/20-3/23/20. The classification of Equity Long-Short and Multi-Strategy mutual funds is according to the GSAM SAS DLA Peer Groups. Chart shows 5th percentile to 95th percentile of fund performance to exclude extreme outliers. Dashed line represents median fund performance. Fund performance refers to net total return. The returns represent past performance. Past performance does not guarantee future results, which may vary. Please see the end notes for additional disclosures.

3. Excessive Manager Concentration

DLAs have generally had more flexibility than traditional long-only funds, resulting in greater return dispersion across managers. Although the median DLA fared much better during the Coronacrisis drawdown than US Large Blend funds, the range of outcomes was nearly 3x as wide. Therefore, if an alternatives sleeve was comprised of only one or two managers, investors were likely frustrated if those managers were at the bottom end of that range. While this heightened degree of concentration risk makes manager diversification even more important, it may not be realistic for all investors to hold more than a couple of managers. For those investors, we believe a potential solution may be to consider utilizing multi-manager strategies, which often consist of 5 or more managers, or hedge fund replication strategies, which seek to mimic the entire universe.

Exhibit 3: Manager outcomes varied widely and may necessitate greater diversification

Source: GSAM and Morningstar. ‘Coronacrisis’ period reflects the peak-to-trough of the S&P 500 from 2/20/20-3/23/20. US Large Cap Blend refers to all mutual funds within the ‘US Fund Large Blend’ Morningstar category. Chart shows 5th percentile to 95th percentile of fund performance to exclude extreme outliers. Dashed line represents median fund performance. Fund performance refers to net total return. The returns represent past performance. Past performance does not guarantee future results, which may vary. Please see the end notes for additional disclosures.

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About the Author

Theodore Enders

Theodore Enders

Global Head of GSAM Strategic Advisory Solutions

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