A Practical Guide to Implementing Liquid Alternatives

Due to the increased integration of the global economy, product innovation, and buyer and seller behavior, investors are finding it more difficult than ever to achieve effective diversification1 across asset classes. As the concept of portfolio diversification evolves in an ever-changing investment market, the role that liquid alternatives play is becoming increasingly more pivotal.

Investors discovered the difficulty of finding diversification during the Great Recession of the late 2000s. Traditional diversification fell short, with most asset classes that aren’t typically correlated dropping in sync. High quality bonds, one of the few traditional investments that provided low correlation, should continue to provide diversification in

portfolios, but today’s low yields and the potential negative impact of rising interest rates are return headwinds for bonds. This reality creates a dilemma for investors who need more than minimal returns while maintaining effective diversification.


Liquid alternatives - total returns in 2008
 

Alternative Investments for Beta-Based Diversification

Alternative investments can complement traditional equity and fixed income strategies to potentially diversify risk and improve long-term risk-adjusted returns. Alternative investments are a diverse group of non-traditional assets or strategies beyond the scope of traditional investments such as fixed income, equities, and cash. They range from specific asset classes that seek to generate returns from a unique and specific market to skill-based strategies that seek to modify risk/return profiles of traditional asset classes.

 

To include alternatives in their portfolios, many investors are turning to a beta-based approach that can assist in evaluating and implementing liquid alternative mutual funds. Beta is designed to help investors better understand risk and to ensure that portfolio exposure is aligned with risk appetite. It is a measure of an asset class’ net exposure, or sensitivity, to a market index, typically the S&P 500.

Beta can help provide deep risk management insights by identifying where risk actually resides in a portfolio. Beta generates an effective reading of the relationship between an asset’s combined correlation (movement) and volatility (magnitude) relative to most investors’ riskiest portfolio holdings, usually U.S. large-cap equity risk. While correlation and volatility are important risk metrics, each has deficiencies on a standalone basis. Correlation measures how closely assets move in tandem, but it doesn’t capture the magnitude of those moves. Volatility measures potential asset price variance, but it doesn’t indicate the direction of the asset’s price movement. Beta captures both movement and magnitude, measuring an investment’s potential directional movement in response to general equity market fluctuations and the extent of the reaction. In the end, understanding beta to large cap equities is vital, because U.S. large-cap equities have historically accounted for over 90 percent of a diversified portfolio’s volatility.3

 

Three-Step Beta-Based Approach to Implementing Liquid Alternatives

1. Beta Awareness

With such a diverse pool of options, it is imperative to compare liquid alternatives across an appropriate metric. Beta is a constructive tool to assist in this comparison. The level of beta does not indicate the quality of an asset class as an investment choice. Rather, beta provides information that can help determine the impact of asset classes on a portfolio’s level of U.S. large-cap equity risk exposure.

Understanding the stability of a strategy’s beta is as equally important as assessing its current level. In times of high market stress, some financial market investments’ betas may deviate substantially. When beta spikes in a market stress environment, such as the fourth quarter of 2008, a portfolio’s equity risk diversification erodes. Many liquid alternative strategies seek to maintain a low or negative beta to U.S. equity risk in times of market upheaval, preserving equity risk diversification.


2. Beta-Based Benchmarking

Because liquid alternatives are vastly different, identifying an appropriate standalone benchmark poses a challenge. However, a suitable benchmark to evaluate and monitor liquid alternatives may be achieved by combining traditional benchmarks to replicate an equity risk profile. Each liquid alternative has unique characteristics that can be benchmarked to some combination of the S&P 500 Index and the Bloomberg Barclays U.S. Aggregate Bond Index

By benchmarking a current portfolio’s beta, an investor can shift a portion of fixed income and equities into a liquid alternative with a similar beta. A liquid alternative investment that has the potential to outperform a blended benchmark of traditional strategies with a similar beta profile can add value to a total portfolio.


3. Beta Implementation

Managing beta exposure can have significant implications for portfolio design. Investment decisions that do not consider embedded U.S. large cap equity risk may inadvertently lower diversification and increase actual risk exposure. Conversely, utilizing beta efficiently may help maintain a portfolio’s risk profile while introducing new investment opportunities that expand return potential.

With a clear awareness of each investment’s beta, investors can evaluate and implement liquid alternatives within their portfolios to maintain their portfolio’s risk profile while seeking potentially greater returns. Investors may consider shifting a portion of their fixed income, equities, or a combination of the two into an alternative investment that has a similar equity beta risk that matches the overall portfolio.

For example, a long-short equity strategy has similar equity beta risk (0.38) to a 50/50 blend of equity and fixed-income (0.49) as of 3.31.2017. In order to seek potential higher returns while maintaining the overall beta profile of a hypothetical traditional 60/40 traditional portfolio, 10% equity and 10% fixed-income (50/50) are reallocated to a 20% allocation in a long-short equity strategy. The overall beta profile of the re-allocated 50/30/20 portfolio (0.57) is similar to that of the traditional 60/40 portfolio (0.59), and an investment solution that may enhance return and diversify risk is introduced into the portfolio

Liquid alternatives - Beta Implementation

With a better understanding of beta and our three-step process for beta management, investors can make informed decisions about diversifying their portfolios and potentially improving their risk/return profiles with liquid alternative investments. Guggenheim Investments offers a range of alternative mutual funds that invest in non-traditional asset classes and strategies. For more information about Guggenheim’s alternative mutual funds, contact your financial advisor today.



Read a prospectus and summary prospectus (if available) carefully before investing. It contains the investment objective, risks charges, expenses and the other information, which should be considered carefully before investing. To obtain a prospectus and summary prospectus (if available) click here or call 800.820.0888.

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Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. Securities offered through Guggenheim Funds Distributors, LLC, an affiliate of Guggenheim, SI, GFIA and GPIM.

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