Liquid alternatives: How diversified is your DC default?

When equity markets go up with consistently low volatility, investing for DC accumulation can seem like a simple task. Many defaults rely on high equity allocations for growth, often using passive vehicles to keep costs low.

But equity markets are not the benign beasts they once were, and neither do bond markets necessarily provide the diversification to absorb any shock.

In 21 per cent of all observations since 1973, equities and bonds suffered negative real returns at the same time, according to asset manager Cohen & Steers. Several reports have shown diversified growth funds to be more correlated with equities and bonds than managers would like to admit.

These strategies may lose money in a market downturn, and they may make money

Keith Guthrie, Cardano

So goes the logic for diversification into alternatives, and modelling by JPMorgan Asset Management appears to support the use of alternative risk premia, a liquid alternative strategy that identifies and isolates return-driving factors with low correlation to equity markets.

ARP strategies provided almost the same returns as a typical DC glide path moving from equities into DGFs and later into bonds, according to JPMAM’s long-term market assumptions.

Crucially, they did so with an improved Sharpe ratio, a measure of risk-adjusted return that takes volatility into account.

Late-cycle diversification could be handy

For Sorca Kelly-Scholte, head of the EMEA solutions and advisory group at the asset manager, this makes a strong case for updating a DC strategy that has focused so far on simplicity.

“Where we are in the cycle and given the size of the assets in these plans, does it make sense to begin to diversify some of this risk?” she said, explaining that the lower volatility does not require much return to be sacrificed.

“The low volatility means it can still work through transition [to a lower-risk portfolio] as well,” she added.

Despite the 'alternative' tag, liquid alternative strategies still trade in equity and other public markets – Kelly-Scholte gave the example of an ARP manager going long on a stock that is likely to be acquired, while shorting the purchasing company.

Others may focus on real asset exposures within liquid vehicles – such as real estate investment trusts, listed infrastructure or commodities – which combined in a diversified manner have been shown to perform well in a stock or bond market downturn.

Complexity is a turn-off

However, their complexity may well be their downfall. “ARP is not a simple product, and as a factory worker, a shop worker… if you see a complex product you may be scared of that,” said Murray Taylor, senior consultant and head of manager research at JLT Employee Benefits.

One important distinction that trustees must be comfortable with is the difference between low correlation and negative correlation, said Keith Guthrie, chief investment officer at fiduciary manager and investment consultancy Cardano.

"Evidence points to these strategies having low correlation with macro environments on average,” he said. “These strategies may lose money in a market downturn, and they may make money; however, over multiple such events there does not appear to be too much of a relationship.”

Moreover, some ARP strategies, like carry or short volatility, do have correlation to macro trends, he said.

Costs can vary

There is also the perennial issue of costs. Kelly-Scholte said JPMAM’s alternative beta funds are well within the charge cap and compare favourably with the similar strategies offered by hedge funds, but Taylor said costs and strategies vary widely, much like another key competitor, the DGF.

Taylor also said there is still a place for exposure to illiquid alternative assets in diversified DC portfolios.

Once the preserve of the largest sophisticated investors, he pointed to funds such as one run by Partners Group, which invests in private markets but offers the daily pricing required by DC schemes.