Alternative investment strategies, including absolute return long-short, risk parity, global macro, or relative value, have historically been used only by the most sophisticated market participants, such as institutional investors and hedge funds. Market participants often seek alternative investments to improve diversification in portfolios, since these strategies tend to exhibit low correlations to the more traditional financial market asset classes of equities and fixed income. Better diversification may lead to higher risk-adjusted returns and lower drawdowns in a portfolio relative to one that only holds stocks and bonds.
However, a drawback of some alternative investments is that they can be relatively illiquid and only appropriate for long-term investment horizons without short-term liquidity needs. Conversely, investing in alternative strategies through liquid instruments, such as exchange-traded futures contracts, can reduce the illiquidity risk, making them a good fit for a broader range of market participants. These strategies, commonly referred to as liquid alternatives, give market participants better access to alternative investments. Additionally, liquid alternatives in an index format provide a systematic rules-based methodology, transparency in pricing, and typically lower cost structure.
There is a wide range of liquid alternative strategies with differing characteristics or key properties as the underlying rationale for construction. A liquid alternative strategy could vary from directional to market neutral to trend following. Directional strategies are typically long-only with low-to-moderate correlation to broad equities, seeking higher risk-adjusted returns relative to the market over the long term. Market-neutral strategies seek to provide purer exposure to certain risk premia in the marketplace by stripping out the market beta. These are typically long-short and target a zero beta, and thus tend to exhibit a low correlation to broad equities. A trend-following strategy seeks to capture price trends by going long or short different assets based on recent price movements, and its correlation to broad equities varies from positive to negative over time. To have a large opportunity set and proper diversification, a trend-following strategy often incorporates multiple asset classes, such as equities, fixed income, currency, and commodities.