In Depth September 2015 Your Global Investment Authority Liquid Alternatives: Considerations for Portfolio Implementation Since the financial crisis, investors have poured nearly half a trillion dollars into liquid alternative strategies – typically mutual funds and ETFs that deploy non- Justin Blesy traditional strategies once reserved for large institutional Vice President i Product Manager investors. These vehicles offer the potential for diversification, downside risk mitigation and attractive risk-adjusted returns with the transparency and daily liquidity many investors desire. Liquid alternatives have been a democratizing force for investors, and we believe today’s market environment arguably has only made Ashish Tiwari Executive Vice President them more attractive. Product Manager Yet implementing liquid alternatives in portfolios presents a complex set of challenges as risk, return and fee profiles vary widely across strategies. In the pages that follow, we present an overview of liquid alternative strategies and considerations for their implementation in portfolios. Liquid alternatives: A search for returns and diversification PIMCO has been managing liquid alternative Typically packaged as mutual funds or ETFs, liquid alternatives investments for well over a decade and, according bring many nontraditional investment strategies once reserved to Morningstar data, is the largest manager of for large institutional investors to a broader investor base. Assets liquid alternative mutual funds in the U.S.ii in U.S. liquid alternative strategies have jumped from less than $100 billion in 2008 to more than $500 billion at the end of ii 2014, with potential for continued growth ahead. Their popularity At the same time, unstable correlations across many assets reflects the turbulence many investors endured with traditional have left investors with fewer reliable portfolio diversifiers. stock and bond portfolios in recent decades, as well as muted For example, the sharp increase in the correlation of stocks forward-looking return expectations for these asset classes. and bonds during 2013’s “Taper Tantrum” left many investors The experiences of the past two decades left many investors concerned about the ability of fixed income allocations to searching for additional sources of return and diversification. diversify their portfolio’s equity risk. They learned, often the hard way, that the majority of their These significant market drawdowns over the past 15 years portfolio’s return and risk had been driven by equities, an asset have resulted in much lower returns than investors experienced class prone to significant drawdowns. Although a traditional in the 1980s and 1990s. During those decades, a traditional 60/40 portfolio has a 60% capital allocation to equities, risk is 60/40 portfolio had an average annualized return of 13.7% driven almost entirely by equities given that equities are much over rolling five-year periods. In contrast, since 2000, investors more volatile than bonds. While this can lead to strong received on average 5.9% and forward-looking expectations performance during equity bull markets, as has been the case are even lower given today’s starting conditions (see Figure 2). in the U.S. since 2009, it can also leave portfolios exposed to As of 30 June 2015, 10-year U.S. Treasury yields of 2.4% were severe drawdowns (see Figure 1). near historical lows, and in stocks, the S&P 500 dividend yield FIGURE 1: THE TURBULENT RIDE OF TRADITIONAL STOCK AND BOND PORTFOLIOS SINCE 1980 Other Traditional Fixed income Rolling 12-month drawdowns 60/40 portfolio Equities Traditional 60/40 portfolio 120 12 0 100 10 -5 80 8 -10 Volatility (%) Volatility 60 6 -15 40 4 -20 Percent (%) Percent Market value (%) 20 2 -25 0 0 -30 -20 -2 -35 Capital allocation Risk allocation ‘80 ‘84 ‘88 ‘92 ‘96 ‘00 ‘04 ‘08 ‘12 Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product. The traditional 60/40 portfolio is represented by 60% S&P 500 Index and 40% Barclays U.S. Aggregate Index. 2 SEPTEMBER 2015 | IN DEPTH was 2.1% with cyclically-adjusted P/E ratios near all-time highs. Fund launches and assets under management (AUM) This stands in stark contrast to the conditions that preceded on the rise the strong bull market in stocks and bonds in the 1980s and The current investment environment has made liquid 1990s, when10-year Treasuries peaked near 16%, dividend alternatives one of the fastest-growing categories in the yields approached 6% and cyclically-adjusted P/E ratios were investment world. Since 2008, the number of funds in the near all-time lows. Today’s environment of lower yields, higher U.S. has tripled to more than 700, and AUM has quintupled to valuations and slower global growth has led to modest long- $500 billion with the number of firms managing these funds term return expectations for stocks of 4.5% and for core bonds reaching nearly 300iii. However, the proliferation of strategies of 2.5%, according to PIMCO’s latest capital market projections presents its own challenges. Researching liquid alternative as of June 2015. strategies can sometimes raise more questions than answers Against this backdrop, liquid alternatives hold out the prospect for investors, including the basic question, “What is a liquid of alternative sources of return and portfolio diversification, alternative?” Additionally, short track records and broad which has in part fueled their growth. flexibility of many liquid alternative strategies make it difficult to understand underlying risk and return characteristics, complicating portfolio construction. FIGURE 2: SINCE 2000, RETURNS FROM TRADITIONAL PORTFOLIOS HAVE FALLEN, WITH PROJECTIONS FOR MUTED FORWARD-LOOKING RETURNS FIGURE 3: LIQUID ALTERNATIVES COME TO MAIN STREET 5-year rolling returns – 25th percentile PIMCO’s 10-year capital AUM Growth Traditional – 75th percentile market assumptions $600 60/40 portfolio Average 18 18 16 16 500 14 14 13.7% 12 12 400 10 10 8 8 300 Percent (%) Percent 6 (%) Percent 6 5.9% 4.5 3.7 (billions) AUM 4 4 2.5 200 2 2 0 0 1980 – 1999 2000 – 2014 U.S. Core U.S. 60/40 100 stocks bonds portfolio Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product. The traditional 60/40 portfolio is represented by 60% 0 S&P 500 Index and 40% Barclays U.S. Aggregate Index. Data on right-hand chart is as of 2008 2009 2010 2011 2012 2013 2014 30 June 2015. Currency Bear market Real estate-linked Commodity Multi-alternative Managed futures Equity market-neutral Long/short equity Nontraditional bond Source: Morningstar, U.S. data, as of 31 December 2014 IN DEPTH | SEPTEMBER 2015 3 Defining liquid alternatives but alternative asset classes and alternative investment Amid the multitude of strategies, defining liquid alternatives strategies can be effective diversifiers for distinctly precisely isn’t simple. At PIMCO, we take a broad view: We different reasons. define liquid alternatives as investments that exhibit Alternative asset classes, such as commodities and emerging modest to low correlation with traditional stock and market currencies, provide exposure to alternative risk premia bond investments and are accessible in broadly available whose returns are driven by different economic drivers than investment vehicles that are without the principal traditional portfolios. Alternative investment strategies, on the lock-ups of traditional private equity funds and hedge other hand, are typically actively managed and not constrained funds. The term “liquid” therefore refers to the vehicle, not by traditional benchmarks. These strategies may provide the underlying investment (which may or may not be liquid). diversification through the manager’s individual security We further divide liquid alternatives into two major categories: selection (or active management alpha), with much less alternative asset classes and alternative investment reliance on broad stock and bond exposures to deliver returns. strategies. In both cases these investments tend to exhibit Examples of alternative strategies include absolute return fixed modest to low correlations with traditional stocks and bonds, income, equity long/short and managed futures (see Figure 4). FIGURE 4: THE LIQUID ALTERNATIVES LANDSCAPE Liquid Alternatives Traditional portfolios Alternative asset classes Alternative investment strategies Traditional stock and bond strategies Investments where primary drivers of Actively managed strategies that include a risk/return are different than long stock higher degree of manager discretion and or bond beta a broader tool kit in an effort to enhance returns and/or diversify risk Categories Categories Active management risk • Currency • Multi-alternative Alternative risk factors • Bear market • Managed futures Stock and bond risk • Real estate-linked • Equity market-neutral • Commodity • Long/short equity • Nontraditional bond Source of risk exposure Source: PIMCO Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product. 4 SEPTEMBER 2015 | IN DEPTH Liquid alternatives: Portfolio considerations In many ways, it is easier to grasp the risk profile of alternative Understanding risk characteristics asset classes, such as real estate investment trusts (REITs), commodities and currencies, since investment products in The varied risk characteristics of liquid alternatives – which these categories often share similar benchmarks.