Written by: Benjamin M. Lavine, CFA, CAIA, Chief Investment Officer, 3D Asset Management
Liquid-Alternative Investing – Harvesting Risk Premiums Outside of Traditional Asset Classes
What is Liquid-Alternative (“Liquid-Alt”) investing? Most Liquid-Alt strategies will target high absolute risk-adjusted returns where the underlying positions, generally invested in publicly-traded assets and derivatives, have low correlations to primary equity and fixed income market risks. Since many of the strategies seek to neutralize these primary market risks, whether beta for equities or interest rate sensitivity for fixed income, some investors will seek to lever their positions to achieve higher returns, especially in a low yield/interest rate environment like the one we’re experiencing today.
From a risk-factor perspective, Liquid-Alt investing can be viewed as an expansion of the traditional factor-based universe (i.e. Fama/French factors such as size, value, and quality as well as momentum, yield, and low volatility) to include alternative risk factors as displayed in Figure 1. By removing the short constraints and adding the ability to invest outside of traditional equities and fixed income, the Liquid-Alt investor is able to harvest more risk premiums than can be found in traditional asset allocation.
Figure 1 – Common Factors Found in Alternative Investing
Investing is About Underwriting Risk
For all its complexities, Liquid-Alt investing can be reduced to this primary bet: the Liquid-Alt investor is forecasting that the implied volatility priced into a ‘trade’ is meaningfully different than its anticipated volatility (typically anchored to historical volatility). Technically, implied volatility is what can be gleaned out of options pricing tied to a particular asset, but it also conceptually captures the risk premium built into a Liquid-Alt trade. Hence, Liquid-Alt investors determine which assets/trades have attractive premiums relative to the risks posed by those positions. The profitability of such a trade can manifest itself in many forms such as:
- A factor-based long-short equity portfolio (neutralized for equity risk) where the valuations of the ‘longs’ narrow versus those of the ‘shorts’ resulting in positive factor performance.
- A fixed income credit portfolio (neutralized for interest rate risk) where the option-adjusted spreads narrow versus risk-free assets.
- A merger arbitrage trade where the valuation of the target company narrows.
- The ‘carry’ on one asset will out yield a similar asset with less carry.
In each of these cases, the market is pricing in some uncertainty (volatility) that the valuation spreads of a known risk premium won’t narrow but, rather widen whether due to a factor underperforming (i.e. in value investing, the inexpensive ‘longs’ underperform the expensive ‘shorts’); corporate credit risk rising (perhaps due to rising default risk); a merger failure causing the valuations of the acquirer and target to revert back to pre-announcement levels; or the real yield differential between a currency with more attractive ‘carry’ versus one with less attractive ‘carry’ widens because the former experiences unexpected inflation or political risk.
If there was no uncertainty (volatility), then the markets presumably would not price it in via a spread between two assets. For instance, if it was near certain that an announced merger would go through, then the stock prices of the acquirer and the target would reflect the expected post-merger value and there would be little to ‘arbitrage’ by going long the target and short the acquirer. In effect, the Liquid-Alt investor is hedging against the uncertainty priced into a risk asset or a risk-based trade; that the market is pricing in too much uncertainty relative to an expected outcome.
JPHF as an Insurer Underwriting Multiple Lines of Risk
Up until recently, investors who build exchange-traded portfolio (“ETP”) models had few attractive and cost-effective options for Liquid-Alt investing. Some providers have rolled out various multi-strategy ETPs that seek to synthetically replicate hedge fund performance, but many of their approaches are built on returns-based regressions between hedge fund returns and potential factors.
In September 2016, JPMorgan Asset Management launched the JPMorgan Diversified Alternatives Exchange-Traded Fund (JPHF) which seeks to systematically capture much of the alternative risk premiums earned by hedge funds and other alternative investors. Rather than a regression-based approach to synthetically replicate what hedge funds might be doing, JPMorgan’s Quantitative Beta Strategies team, led by Dr. Yazann Romahi, uses internal models to build baskets that deliver alternative risk premium covering quantitative long/short equities, global macro, and event-driven risks commonly found in alternative strategies. In other words, JPHF delivers to investors alternative risk premiums built from the security up rather than synthetically replicating those exposures through other asset classes. JPHF also takes on both modest equity and interest rate sensitivity risk. By doing so it complements a traditional asset allocation of equities and fixed income.
What JPHF offers is an opportunity to systematically capture much of the alternative risk premiums that can be sourced to alternative investing. For instance, currency specialists will typically incorporate ‘carry’ or yield, ‘trend’ or relative performance, and ‘volatility’ or a preference for low volatile currencies versus highly volatile currencies. Commodity Trading Advisors (“CTAs”) employing managed futures strategies will commonly incorporate ‘trend’ into their models as well as for the possibility of short-term mean reversion. Capturing ‘carry’ and ‘trend’ are two of the strategies implemented in JPHF within the global macro category.
So, investors in the fund can feel more confident they’re being given exposures to alternative risk premiums, especially with the daily transparency afforded by ETPs. This allows an investor to build a Liquid-Alts program using JPHF as the ‘core’ allocation. Some other satellite strategies that could be built around JPHF include volatility-based strategies (i.e. tactical long/short volatility, put-write or buy-write option strategies) and credit-based strategies that include or hedge out interest rate sensitivity. So, investors now have more cost-effective opportunities to build a Liquid-Alts portfolio that hedges against multiple risks while collecting risk premiums with low correlations to traditional equity and fixed income risk.
Some Final Thoughts on Liquid-Alt Investing – Pay Attention to Price and Leverage
Readers of former WSJ journalist-turned-author Roger Lowenstein may remember, “When Genius Failed – the Rise and Demise of Long-Term Capital.” The 1997 collapse in Southeast Asian currencies (starting with the Thai Baht) and 1998 collapse of the Russian ruble helped instigate a global-wide risk-unwind tailspin that ultimately forced Long-Term Capital Management (“LTCM”), a hedge fund, to liquidate its leveraged positions at unfavorable prices that almost brought the U.S. banking system to its knees since most of Wall Street had been serving as counterparties to LTCM.
What are the main lessons that can be drawn from LTCM’s collapse? LTCM’s primary problem wasn’t its models which largely combined trend and mean reversion, but its size, which was exasperated by tremendous leverage. Its growth also forced the fund to invest in areas outside the firm’s core competencies such as merger arbitrage as well as to become less price sensitive in overall allocation (i.e. the money was coming in faster than they could put it to work). An unlevered or modestly levered portfolio can afford to absorb hits from time-to-time (and perhaps wear out the patience of its investors), but such hits shouldn’t result in a massive liquidity-driven unwinding of positions.
Liquid-Alt investors should always pay attention to price and leverage (as well as the sources financing that leverage, so you don’t get a margin call at the worst possible moments). Price is harder to navigate because one can only know if an asset or risk-trade is priced too high or too low after-the-fact, but investors should at least be cognizant of whether they are being properly compensated for the risks taken in the portfolio.
Call 1-844-4JPM-ETF or visit www.jpmorganetfs.com to obtain a prospectus. Carefully consider the investment objectives and risks as well as charges and expenses of the ETF before investing. The summary and full prospectuses contain this and other information about the ETF. Read them carefully before investing.
Disclosure: At the time of this writing, 3D Asset Management held a position in JPHF. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
 A good example is applying the Merton options pricing model to risky fixed income (credit risk). Owning risky debt, such as high yield, can be viewed as holding two positions: 1) Risk-free debt and 2) Short position in a put option that allows the stockholders to ‘put’ the assets of the company back to the debt holders without further liability (in exchange for the debt). If the assets perform well, the put expires worthless, and the debt holder receives the riskless rate plus a credit premium equal to the price of the put that was written.
 A full literature review of alternative risk factors goes beyond the scope of this paper. We suggest you refer to 1) “Inside the black box – Revealing the alternative beta in hedge fund returns.” Romahi, Yazann et al., December 2016, J.P. Morgan Asset Management Investment Insights and 2) “Factor Investing Risk Allocation: From Traditional to Alternative Risk Premia Harvesting.” Maeso, Jean-Michel and Martellini, Lionel, Summer 2017, The Journal of Alternative Investments.
 Maeso, Jean-Michel and Martellini, Lionel, pp 27-28.
 “When Genius Failed – the Rise and Demise of Long-Term Capital.” Lowenstein, Roger, 2000, Random House Trade Publications, New York, NY.
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