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How liquidity-conscious investors can tap hedge-fund-like returns

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This is a sponsored article from Credit Suisse.

By Yung-Shin Kung, Head & CIO, Quantitative Investment Strategies, Credit Suisse Asset Management

Although we are heading into the second half of 2023 on a wave of positive returns, last year’s dismal market performance continues to shape how investors think about asset allocation.

2022 was one of the worst years in history for markets amid a more volatile geopolitical situation, sustained inflation, aggressive interest rate hikes from central banks worldwide, and persistent recession fears. It was a rare period when both bonds and equities plunged, along with most other asset classes.

The MSCI World stock index was down nearly 18%, while the Bloomberg Global Aggregate debt benchmark fell 13% – its most significant loss since it began in 1976. The average 60% equity/40% fixed income portfolio lost about 17% – the worst annual performance on record since the Great Depression.

However, hedge funds, which often trade across assets and markets, outperformed public markets in 2022. Managed Futures and Global Macro were the two best-performing hedge fund strategies, gaining 19.1% and 15.9%, respectively, in 2022, while the industry in aggregate gained 1.1%, according to the Credit Suisse Hedge Fund Index.

This divergence has, not surprisingly, unleashed a surge of interest in alternative investments. Making or increasing an allocation to alternatives, however, is easier said than done. Many investors are unable or unwilling to accept the lack of liquidity common to private vehicles.

Investors wishing to gain exposure to the hedge fund industry can consider using liquid securities that track a diversified portfolio of alternative investments. In the proper quantitative, rules-based framework, such strategies can replicate the performance of the hedge fund sector without the high entry requirements and lengthy lock-up periods typical of alternative investments.

More turbulence ahead?

Despite a solid first half of 2023 for most asset classes, we believe the case for diversification remains as strong as ever. Inflation in developed markets has moderated but remains well above central bank targets, interest rates are still rising in various major economies, the threat of recession is looming, and geopolitical tensions remain elevated, most notably related to the Russia-Ukraine conflict and China-US relations.

Central banks thus face a trickier task than usual of trying to calm inflation while avoiding recession. In markets such as the UK and the US, expectations had been widespread earlier in the year that a series of rapid rate hikes would quickly tame fast-rising prices. The impact of tightening has been more limited than expected – especially in the UK, where there is talk of rates possibly climbing as high as 7%.

The upshot is that global market turbulence is unlikely to ease any time soon.

In this uncertain environment, rules-based liquid alternative investments may offer a means of improving the portfolio risk-return characteristics. Such strategies have a low correlation to most other asset classes, and well-designed programs can quickly adapt to changing market conditions.

Range of features

Established liquid alternative funds often seek to provide broadly diversified exposure to the risk and return characteristics of hedge funds. They typically invest in equities and equity-type securities, fixed-income securities, cash and cash equivalents, currencies, and financial derivative instruments. Some even offer inverse exposure, which may be useful for hedging and risk management.

Liquid alternatives also incorporate other features which may suit certain investors. Thanks to their diversified and tactical nature, they provide greater stability than most single asset class investments that aim to generate robust cumulative long-term returns. Diversification is a critical component of their appeal. These solutions tend to avoid the greater concentration and counterparty risks that can come with an allocation to a single alternative asset manager.

A mathematical, rules-based approach contributes to stability and low market correlation by avoiding emotion and other behavioural biases. That can be a major benefit at times of geopolitical turmoil and tensions, as well as heightened market stress.

Quantitative approaches offer methodological and exposure transparency, which can be particularly helpful to investors subject to various regulatory and reporting regimes. Additionally, their performance is typically measured against an industry benchmark, promoting expectation setting and unambiguously clarifying their “alpha.” These strategies can generally be tailored and optimised to suit different levels of risk tolerance and around different market regime expectations on an ongoing basis.

Moreover, liquid alternatives are flexible and scalable investments, given that they allocate across asset classes, geographies, and instrument types in public markets. Without lock-ups, they potentially allow investors to be more flexible in the size and speed of their allocations than is generally possible through private vehicles.

Liquid alternatives and quantitative strategies are far from new concepts. However, the past 18 months have proved that standard portfolio diversification is not always sufficient to protect investors against market dislocation. Hedge funds and other alternative investments have much to offer, and liquidity-focused investors need not miss out.

This document was produced by and the opinions expressed are those of Credit Suisse as of the date of writing and are subject to change. It has been prepared solely for information purposes and for the use of the recipient. It does not constitute an offer or an invitation by or on behalf of Credit Suisse to any person to buy or sell any security. Any reference to past performance is not necessarily a guide to the future. The information and analysis contained in this publication have been compiled or arrived at from sources believed to be reliable but Credit Suisse does not make any representation as to their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Nothing in this document constitutes investment research or investment advice and may not be relied upon. It is not tailored to your individual circumstances, or otherwise constitutes a personal recommendation, and is not sufficient to take an investment decision.

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This is a sponsored article from Credit Suisse.