Insights

Traditional portfolios face growing challenges in delivering diversification when it matters most. We explore how liquid alternatives can expand the opportunity set and strengthen portfolio construction.

Part 1: The Role of Liquid Alternatives

The portfolio construction challenge

At its core, the portfolio construction challenge for investors is to maximise return outcomes, subject to binding constraints on volatility, liquidity, and drawdown risk.

This definition is deliberately broader than the usual industry shorthand of ‘maximising risk-adjusted returns’, because in practice, investors have other considerations beyond volatility:

• Liquidity – can I meet cashflow needs when I need to?
• Drawdowns – can I mitigate sequencing risk? (This is particularly important for retirees and those nearing the decumulation stage.)

There are of course many ways for investors to increase returns in isolation – for example, by increasing equity beta, using leverage, concentrating risk in fewer positions – but most of those approaches violate one or more of these constraints.

Historically, the most reliable way to improve return outcomes without compromising on these constraints has been diversification – and specifically, diversification across independent sources of return. This is an important distinction from another industry shorthand, ‘uncorrelated returns’, which can be a useful indicator but are ultimately a backward-looking statistical measure. When returns are based on structurally independent drivers, diversification has the greatest chance of holding up in the future.

The traditional approach to portfolio diversification has been to blend equities and bonds, with the ‘60/40’ portfolio perhaps the most widely known example. This approach has worked well across long periods of time and across most market environments, but it is important to note that both asset classes are directional exposures – meaning they primarily depend on markets moving in a particular direction, such as equities rising or interest rates falling, and if the market moves the “wrong” way, returns suffer regardless of skill. Both are also driven by a relatively narrow set of return drivers, broadly related to economic growth (e.g. corporate earnings, inflation, credit spreads) and government policy (e.g. interest rate changes, fiscal spending).

This means that while equity-bond portfolios are very effective in most environments, there can be periods of poor performance, including inflation shocks (as seen in 2022), volatility shocks, and broader market dislocations. As a result, they may not provide true diversification or liquidity when investors need it most, even when appearing uncorrelated – as the old market adage goes, “all correlations go to one in a crisis”.

Liquid alternatives expand the opportunity set

This is where liquid alternatives can play a role. Liquid alternatives are best thought of not as a single asset class, but as a way of accessing different types of return drivers in a liquid (daily-priced), often transparent format, without capital lock-ups. These drivers broadly fall into two groups:

• Non-directional strategies – these aim to generate returns based on the relationships between securities, not market direction, through relative value, arbitrage or pricing inefficiencies. Examples include market-neutral equities, pairs trading, or convertible arbitrage.
• Alternative risk premia – these are systematic sources of return distinct from equities and bonds, such as trend/momentum, carry, or liquidity premia. These premia exist for structural reasons, such as behavioural biases, market frictions, or risk transfer, and they tend to behave differently from traditional assets across market environments.

Importantly, liquid alternatives are not a promise of outperformance; they are a portfolio construction tool. They expand the opportunity set by allowing investors to reallocate risk across a broader set of return drivers, complementing traditional assets and strengthening diversification. As the market environment in 2022 highlighted, diversification across asset classes alone is not always sufficient; access to a broader set of return drivers remains as relevant as ever.
 

Part 2: classifying liquid alts: a return driver framework 

To distinguish between different liquid alternatives funds it is helpful to classify them based on the investment strategies used. However, it is important to recognise that these strategies often do not fit neatly into specific categories. Many strategies overlap, shift over time, or combine multiple approaches. Even within professional investment circles, there is disagreement about where certain strategies begin and end, and how they should be grouped.

One practical way to think about liquid alternatives is to group them into a small number of broad strategy types based on investment style and return drivers, noting that each type can involve trading diverse financial instruments.

Global Macro

Global macro strategies seek to profit from macroeconomic trends and policy dynamics across countries and asset classes. Positions may be directional, such as taking views on interest rates, currencies or commodities, or may express views on relative value between related markets or instruments.

What defines global macro is not the asset traded, but the lens through which decisions are made. Trades are driven by views on growth, inflation, monetary policy, fiscal dynamics or geopolitical developments, rather than by company specific fundamentals or purely technical signals.

The breadth of this opportunity set creates significant dispersion between managers. Outcomes depend heavily on skill, judgment and timing, and performance can be sensitive to shifts in market volatility. As a result, global macro strategies can deliver strong diversification benefits, but they also require careful manager selection and a clear understanding of risk exposures.

Managed Futures and CTA Strategies

Managed futures strategies (often referred to as CTAs) are fundamentally different from discretionary macro. These strategies trade highly liquid futures markets across equities, bonds, currencies and commodities, and are typically implemented through systematic, rules based processes.

The most common signals include trend following or momentum, carry and counter trend strategies, often using technical indicators such as moving averages. Because they rely on deep, liquid markets and can be scaled up or down efficiently, managed futures are particularly well suited to daily liquid investment vehicles.

While managed futures strategies can appear similar at a headline level, outcomes vary meaningfully depending on time horizons, signal construction and assets traded. Correlations between managers may rise during highly volatile markets or strong trending markets, but over full cycles these strategies can behave very differently.

Relative Value and Arbitrage Strategies

Relative value strategies aim to exploit mispricings between related securities. Rather than relying on market direction, they focus on spreads between instruments, betting that prices will converge or normalise over time. These strategies are designed to generate modest but consistent returns across a range of market environments.

Types of relative value strategies include:

• Volatility arbitrage: Aims to take advantage of differences in implied volatility of option prices, utilising dispersion trades, variance swaps and volatility swaps. 
• Fixed Income arbitrage: Involves trading fixed income instruments based on perceived mispricings that will correct (rather than macro views) e.g. yield curve trades, swap spreads, bond vs futures, sovereign spread trade
• Commodity relative value: Seeks to profit from price relationships between commodity instruments, not a directional bet on commodities, using trades such as calendar spreads, location spreads, inter-commodity spreads
• Convertible bond arbitrage: Involves taking a long position in a convertible bond and a short position in the underlying stock, to exploit mispricing in convertible bonds which tend to be underpriced. Liquid alternatives generally only trade the most liquid convertible bonds.

Because expected returns per trade are relatively small, relative value strategies often rely on leverage. In liquid alternative structures, however, leverage constraints limit how aggressively these strategies can be implemented, resulting in more controlled risk profiles and improved transparency.

Equity Long/Short and Market Neutral Strategies

Equity based liquid alternatives include long/short, market neutral and short biased strategies. These approaches are driven by stock specific analysis, such as company fundamentals, valuation metrics or factor exposures, rather than macroeconomic views.

The objective is to generate returns from security selection while managing overall market exposure. Market neutral strategies, for example, aim to minimise exposure to broad equity market movements, while long/short strategies may retain a degree of net market bias.

Event Driven Strategies

Event driven strategies seek to profit from specific corporate events, such as mergers and acquisitions. In liquid alternative vehicles, these strategies typically focus on large capitalisation transactions with sufficient liquidity to support daily dealing.

Given the constraints of the structure, event driven strategies are often used as a complementary allocation rather than a core standalone exposure and may represent a smaller sleeve within a broader multi strategy portfolio.

Overall, liquid alternatives are a key part of portfolio diversification.

This material has been prepared by  Fidante Partners Limited ABN 94 002 835 592 AFSL 234668 (Fidante). The information in this material is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. Neither of Fidante nor any of its respective related bodies corporate, associates and employees, shall have any liability whatsoever (in negligence or otherwise) for any loss howsoever arising from any use of the material or otherwise in connection with the material. It is intended to provide general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. Any projections are based on assumptions which we believe are reasonable but are subject to change and should not be relied upon. Past performance is not a reliable indicator of future performance. Fidante, its related bodies corporate, its directors and employees and associates of each may receive remuneration in respect of the financial services provided by Fidante.