Volatility spikes that accompanied the financial crisis of 2008 and multiple risk-off events since – think U.S. debt ceiling crisis in 2011, Greece and China more recently – have led investors to seek ‘alternative’ or non-correlated assets to better diversify their portfolios. Liquid alternatives (liquid alts) have answered this siren call of investors, giving them access to hedge-fund like, alternative investment managers but with the liquidity benefits of mutual funds or ETFs. The ostensible goal of these alternative vehicles is to help protect investment portfolios against sharp downturns while also participating in positive markets – providing ‘absolute’ returns, if you may.
The most common refrain you hear regarding alternatives is that they have low ‘beta’, which essentially measures the volatility of a strategy relative to the market, and often thought of as a proxy for risk. However, we pointed out in a previous post that investors should be wary of using beta as a measure of risk, since it downplays the actual risks that are taken. We looked at historical hedge fund returns and saw how the volatility and diversification benefits that alternative strategies offer comes from altering the payoff structure when markets go up, as opposed to taking on different risks.
In other words, your typical alternative strategy acts similar to a covered call strategy, in which an investor sells away upside exposure to protect part of the downside. The payoff structure is concave – with higher beta in down markets and lower beta in up markets.
The question is whether this characteristic has carried over to the universe of liquid alts.
The Payoff Structure of Liquid Alternatives
We use the universe of Morningstar’s multi-alternative mutual funds, as a proxy for liquid alts. However, we use daily data as opposed to monthly data (as in our previous post ), which gives us a large sample of data for each fund. We consider only those funds that had been around for at least three years as of December 31st 2015, and include only the institutional share class for those funds with multiple share classes. We found fifty-nine funds with available daily data (from Yahoo! Finance ) between 2013 and 2015.
Before we look at the payoff structure for liquid alts, it will help to establish a baseline i.e. something we can compare the results to. For this purpose, we use daily data for the PowerShares Buy-Write S&P 500 ETF ( ticker: PBP ), which tracks an index measuring the total rate of return on an S&P 500 covered call strategy. The strategy involves:
Quite obviously, one would expect the payoff structure in this case to be concave – since selling a call option caps the upside while still keeping most of the downside. The following scatter plot, relating the ETFs daily returns to corresponding returns for the S&P 500 index (market), confirms the behavior, with a best-fit curve having a negative coefficient on the quadratic (squared) term.
The concave nature of the payoff structure can be better seen when you look at realized betas in strong up markets versus strong down markets. We define an ‘up-market’ as a day when the S&P 500 index rises by 0.5% or more and a ‘down-market’ as a day when the S&P 500 falls by 0.5% or more. Days in between, when market returns were between -0.5% and 0.5%, are considered as ‘flat’.
There were 756 trading days during the three years between 2013 and 2015, of which 193 days (~ 26%) fell into our definition of an up-market, while 145 days (~ 19%) classify as down-markets. The following table shows the beta of the buy-write ETF over the entire three year period, as well as the beta in up-markets and down-markets. We’ve also included a few other asset classes, proxied by ETFs, in the table for comparison.
As you would expect, the buy-write ETF has a higher beta when the market falls (0.99) versus days when the market rises significantly (0.80). Interestingly, the betas for some of the other ‘alternative’ asset classes, like REITs, commodities and Gold, also have higher betas in down-markets than in up-markets. This hints at what we should expect when we look at the liquid alts universe.
The average beta for all fifty-nine liquid alt funds over the three years was 0.26. At the same time, the average beta in down-markets rose to 0.29, which is almost 50% higher than the average beta in down-markets.
Of the fifty-nine liquid alts funds that we consider here, only four had a realized beta in up-markets that was larger than their realized beta in down-markets (of which one had an up-market and down-market beta within 2% of each other). All the remaining fifty-five funds had higher betas in down-markets.
We also broke the funds down into quartiles of their overall period beta and the result remains in each case, as the next table shows.
The quartile results in the table indicate that the overall average values are not skewed by a few outlier funds. In each quartile, the overwhelming majority of funds have a higher exposure to down-markets than up-markets.
The concave payoff structure of these liquid alt funds is readily apparent in the following chart, which is a scatter plot of the daily returns averaged across all fifty-nine funds versus corresponding returns for the S&P 500 index (market).
As in the case of the buy-write ETF that we saw earlier, the best-fit curve shows a concave profile, with a negative coefficient on the squared term.
We saw above that the average liquid alt fund has a beta of 0.26, which puts it right in line with the traditional definition of alternatives. Yet, this masks an important characteristic of these funds, which is that their beta is actually higher when equity markets fall (0.29), as opposed to when the market rises (0.20).
It appears that liquid alts have maintained the chief characteristic of their hedge-fund kin, namely, higher exposure in down markets than in up markets. Understanding this is crucial to investing in alternatives, in that the average alternative fund is not taking different risks. Instead, it achieves its volatility and diversification benefits by altering the payoff structure when markets go up. Essentially, upside exposure is exchanged for a premium, which protects part of the downside, but crucially, not all of it. In a future post I will tackle some of the consequences of this feature, i.e. whether concavity is good or bad.