Insights

Introduction

Institutional portfolios have rarely faced a more complex backdrop. Structural shifts in geopolitics, persistent fiscal deficits in the major economies, the disruptive implications of artificial intelligence, and the growing disconnect between market volatility and underlying uncertainty have combined to create an investment landscape that looks markedly different from the one that shaped the past two decades.

For professional investors, this new world presents a clear challenge: traditional diversification is less reliable, equity beta is more fragile, and the cost of protection is persistently high. In this environment, liquid alternatives deserve renewed scrutiny – not as peripheral return enhancers, but as core tools of portfolio construction.

However, to play that role effectively, liquid alternatives must be bold, flexible, and thoughtfully funded. They must deliver more than cosmetic diversification. They must be capable of outperforming their funding source over time, generating meaningful convexity in periods of stress, and doing so with sufficient volatility to matter.

Liquid alternatives occupy an increasingly important role in institutional portfolios, but the bar is high. We explore some of the characteristics that we think make a liquid alternatives product fit for purpose as a diversification tool in today’s challenging market environment.

What is the purpose of Liquid Alternatives?

When they are working well, liquid alternatives serve four key functions.

First, they provide diversification during periods of equity market stress. This is the headline objective, but it is also the most misunderstood. True diversification requires more than low historical correlation. It requires the capacity to rise materially when other assets fall, especially if that occurs over a prolonged period.

Second, they should outperform their funding source over time. Too often, liquid alternatives are judged in isolation. But portfolios are funded entities. Allocating to an alternative strategy implicitly means reducing exposure elsewhere. If the alternative does not deliver a long-term realised return that is higher than what it replaces, the portfolio is likely to be worse off.

Third, they aim to generate a smoother path of returns. Behavioural realities matter, and investors and committees have loss thresholds. Large drawdowns increase the probability of poor decision-making, forced de-risking, and the permanent impairment of capital.

Fourth, liquid alternatives should deliver alpha more cost-effectively than traditional hedge funds, with more simple fee structures and, ideally, with greater transparency. The more liquid, daily dealing alternatives also represent a structural advantage, avoiding the lock up of client capital that is commonly associated with hedge funds, providing greater flexibility.

Together, these objectives are demanding. Meeting them simultaneously requires clarity of design and discipline in implementation. The most robust approach is to target positive expected return with episodic convexity. In other words, build strategies that can win in multiple environments, including, but not exclusively, during periods of stress.

The core challenge: Diversification is complex

Delivering genuinely uncorrelated returns is not straightforward. Liquid alternatives trade traditional asset classes (equities, rates, currencies and commodities) but they must do so differently. Generating diversification from instruments that are widely owned and efficiently priced requires complexity in approach, instruments, and portfolio construction.

Moreover, the funding decision is often underappreciated. What exactly is being replaced? Equities? Credit? Government bonds? Cash? The answer determines the hurdle rate and shapes the assessment of success.

Where one of the goals is to limit the magnitude of drawdowns, as with all ‘insurance-like’ strategies, smoothing returns comes at a cost. Strategies that systematically dampen volatility often bleed returns in benign environments. The drag may be modest in isolation, but over time it compounds. If not carefully managed, the cost of insurance can overwhelm its benefit.

At the same time, the cost of generating alpha has risen. Many systematic edges have been arbitraged with the rapid diffusion of information and so managers are required to be smarter in the way they access opportunities. The more complex the position, potentially the higher the cost of implementation.

Together, these challenges raise the bar for what constitutes a compelling liquid alternative. The implication is clear: liquid alternatives must be designed not as permanent short equity overlays or structurally defensive exposures, but as dynamic, opportunistic strategies with sufficient expected return to justify their capital allocation.

Important considerations: Source of funding & target volatility

Having decided to invest in a liquid alternative strategy, there are some important considerations that you need to factor into your choice of manager. One of these is the source of funding, and the other is the fee, specifically the fee per unit of volatility.

Consider a liquid alternative strategy expected to deliver cash plus 4-6% with moderate volatility. Funded from equities, it may reduce expected return when compared to the long-term equity risk premium, but it could also materially improve drawdown characteristics. Funded from cash, it may represent an efficient redeployment of liquidity. Funded from bonds, however, in a regime where bonds are structurally challenged in their role as a diversifier, it may enhance both expected return and diversification. This relationship is illustrated in Chart 1:

Chart 1: Considering the relationship between target volatility and the source of funding

Source: Fulcrum Asset Management LLP

It might sound obvious, but many allocations are made with insufficient attention to this comparison.

Volatility is another critical, and often overlooked, dimension. Liquid alternatives should run with sufficient volatility to give them the potential to outperform their funding source. Overly constrained strategies may look comfortable in isolation but may fail to move the needle at the total portfolio level.

Higher volatility strategies typically appear more expensive when assessed on a simple fee analysis. But if they deliver proportionately higher expected returns, or if less capital is required to achieve the same portfolio impact, they may be more efficient. What matters is not the fee rate in isolation, but the fee per unit of volatility. It’s important to assess this as part of the selection process, as Chart 2 shows:

Chart 2: The importance of considering fees per unit of volatility

Source: Fulcrum Asset Management LLP

What drives alpha in Liquid Alternatives?

The next important consideration in the selection process is the quality of alpha in the strategy. Because liquid alternatives trade traditional asset classes, their alpha quality depends on how they generate returns.

Three concepts are central: breadth, asymmetry and hit ratios.

Breadth refers to the number of independent opportunities a strategy can exploit. Greater breadth improves the reliability of outcomes, provided exposures are genuinely differentiated. This can be achieved in a number of ways, including across asset classes, geographies, time horizons and implementation methods.

However, breadth must be balanced against leverage risk. Expanding opportunity sets further via use of leverage, using instruments at the more complex end of the investment spectrum (such as options, for example), can enhance capital efficiency but increases the risk of forced deleveraging in adverse conditions. Judicious use of leverage and turnover, as well as having a robust and fully integrated approach to risk management, can expand breadth without compromising resilience.

Asymmetry measures the ratio of the average gain on winning trades to the average loss on losing trades and it matters because the distribution of returns is not symmetric. Strategies that combine small, controlled losses with occasional large gains can be powerful portfolio diversifiers. Convex payoff structures – achieved both by the use of options and created dynamically through trading – are particularly valuable when market shocks reshape correlations.

Hit ratios – the proportion of profitable trades – are also key. A strategy that can deliver a high hit ratio as well as asymmetry is highly desirable.

Chart 3: Sharpe ratios improve with both breadth and asymmetry*

Source: Fulcrum Asset Management LLP

The interaction of these three elements helps to determine the quality of alpha. Chart 3, above, illustrates how the interaction of breadth (shown as the number of constituent strategies) and asymmetry can impact the Sharpe ratio of the strategy.

In a crowded marketplace, generating a durable and repeatable edge is more likely to come from highly diversified portfolios (that ideally also deliver an attractive hit ratio and a degree of asymmetry and are respectful of the risk of increased leverage) than from narrow, one-dimensional trades.

Designing the portfolio: Macro shocks and the instability of correlations

Another factor that should drive the selection process is the ability of the strategy to be able to identify different macroeconomic shock regimes, and to be able to capitalise and provide true diversification through the use of dynamic positioning.

Traditional portfolio construction often relies on historical correlations. Yet correlations are unstable. They are not random, but regime dependent. For example, when demand shocks or flight-to-safety episodes dominate, equities and bonds tend to be negatively correlated, so bonds have historically been used as a hedge to equity risk. This was the prevailing regime for much of the post-Global Financial Crisis period. On the other hand, when supply shocks or monetary policy shocks dominate, the correlation between equities and bonds can turn positive. In such regimes, bonds may fail to hedge equity risk. The experience of 2022 is a stark reminder, as is March 2026.

The key insight is that correlations depend on the macro shock at play. Predicting specific macro outcomes is notoriously difficult. But identifying the nature of the shock (demand versus supply, policy easing versus tightening, inflationary versus deflationary) is more manageable.

For portfolio construction, this distinction is powerful. Liquid alternative strategies that dynamically position for different shock regimes can provide diversification precisely when static allocations fail.

Controlling bleed from hedging in good times

Finally, a good strategy is one that incorporates dynamic hedging, rather than static protection.

A persistent challenge for liquid alternatives that are also focused on downside protection is the ‘bleed’ from the cost of hedging, as well as from option premia and the like, during benign environments. These strategies can experience steady losses in calm markets. While occasional stress events may compensate, the path dependency can erode investor confidence.

Controlling this bleed requires flexibility. Rather than maintaining static protection, it’s helpful if managers adapt exposures to prevailing regimes, monetising hedges where appropriate and dynamically adjusting option structures, or expressing convex views in ways that are less carry intensive.

At the same time, the shocks that they are trying to protect against often create structural trends and correlation breaks. These episodes generate opportunities not only on the left tail (risk-off events) but also on the right tail (unexpected accelerations, regime shifts, asset re-ratings).

Two-way convexity is therefore desirable. Examples might include long-dated digital puts on equity indices to capture deep downside scenarios; call spreads in commodities to benefit from supply shocks; or cross-asset structures that pay off when currencies and equity markets rally together in unexpected combinations.

The objective is not permanent defensiveness, but the ability to monetise dislocations—wherever they occur.

The behavioural dimensions: The strategy you can stick with

Most investors have implicit loss thresholds. Beyond these, the probability of behavioural responses rises sharply. Panic selling, abrupt de-risking, or the abandonment of long-term plans can transform temporary mark-to-market losses into permanent capital impairment.

A smoother path of returns can therefore be valuable. By mitigating drawdowns and stabilising outcomes, liquid alternatives can help investors adhere to their strategic allocations.

Chart 4 shows two hypothetical strategies, one higher volatility than the other, highlighting the potentially more uncomfortable journey for the investor who decides to allocate to a higher volatility strategy. In the event of a drawdown that exceeds the investor’s threshold for losses, there is a good chance that they will choose to redeem their investment, potentially impairing their ability to generate attractive long-term returns by missing the recovery phase.

Chart 4: An investment approach that seeks to avoid the long-term impairment of capital

Source: Fulcrum Asset Management LLP

However, smoothing should not be confused with suppressing volatility at all costs. Excessive dampening may compromise long-term return potential. The optimal approach balances sufficient volatility to generate meaningful returns with enough resilience to avoid catastrophic losses.

In this sense, the ‘best’ investment approach is often the one that investors can stick with through cycles. Liquid alternatives, thoughtfully constructed and incorporating the elements that we have outlined above, can support that objective.

Conclusion: Raising the bar

Liquid alternatives occupy an increasingly important role in institutional portfolios. But the bar is high.

They must:

• Run with sufficient volatility to outperform their funding source
• Emphasise breadth as a driver of alpha quality
• Use leverage and turnover judiciously to expand opportunity
• Seek two-way convexity to profit from shocks across asset classes
• Control bleed in benign markets while remaining poised for dislocation

In a world defined by structural change and macro uncertainty, timid diversification is unlikely to suffice. Investors should demand liquid alternatives that are bold in opportunity set, flexible in implementation, and disciplined in portfolio construction.

Written by: Helen Roughsedge

*Chart sourced from “Don’t Bet the Ranch: Hit Ratios, Asymmetry and Breadth”, a white paper by Suhail Shaikh, available here: https://fulcrumasset.com/insights/investment-insights/dont-bet-the-ranch-hit-ratios-asymmetry-and-breadth/

This content is provided for informational purposes and is directed to clients and eligible counterparties as defined in Directive 2011/61/EU (AIFMD) and Directive 2014/65/EU (MiFID II) Annex II Section I or Section II or an investor with an equivalent status as defined by your local jurisdiction.  Fulcrum Asset Management LLP (“Fulcrum”) does not produce independent Investment Research and any content disseminated is not prepared in accordance with legal requirements designed to promote the independence of investment research and as such should be deemed as marketing communications.  This document is also considered to be a minor non-monetary (‘MNMB’) benefit under Directive 2014/65/EU on Markets in Financial Instruments Directive (‘MiFID II’) which transposed into UK domestic law under the Financial Services and Markets Act 2000 (as amended). Fulcrum defines MNMBs as documentation relating to a financial instrument or an investment service which is generic in nature and may be simultaneously made available to any investment firm wishing to receive it or to the general public. The following information may have been disseminated in conferences, seminars and other training events on the benefits and features of a specific financial instrument or an investment service provided by Fulcrum.

Any views and opinions expressed are for informational and/or similarly educational purposes only and are a reflection of the author’s best judgment, based upon information available at the time obtained from sources believed to be reliable and providing information in good faith, but no responsibility is accepted for any errors or omissions. Charts and graphs provided herein are for illustrative purposes only. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Some of the statements may be forward-looking statements or statements of future expectations based on the currently available information. Accordingly, such statements are subject to risks and uncertainties. For example, factors such as the development of macroeconomic conditions, future market conditions, unusual catastrophic loss events, changes in the capital markets and other circumstances may cause the actual events or results to be materially different from those anticipated by such statements. In no case whatsoever will Fulcrum be liable to anyone for any decision made or action taken in conjunction with the information and/or statements in this press release or for any related damages. Reproduction of this material in whole or in part is strictly prohibited without prior written permission of Fulcrum Copyright © Fulcrum Asset Management LLP 2026. All rights reserved.

FC1720 020426