Allocating to Liquid Alternative Strategies for Mean–Variance Diversification

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Buyers of alternative investments need to make an allocation decision in a broader portfolio context that includes traditional assets—how much to allocate and from where to fund? Permissible allocations are often capped, and formulating explicit return assumptions is particularly challenging. Focusing on “liquid alternative” mutual funds, the author introduces a framework to assess such an investment purely in terms of its risk by using mean–variance considerations to extract the return threshold that would justify a moderate, realistic allocation. The framework reveals nuanced relationships between the risk properties and attractiveness to the broader portfolio: Both greater volatility and a lack of equity market correlation can be advantageous in the sense of lowering this return threshold. Comparing the empirical performance of liquid alternative investments (which includes the sell-off in 2020) with the return thresholds implied by this framework suggests that only a minority of funds have historically cleared the threshold that merits investment, with some differentiation across subcategories observed. <b>TOPICS:</b>Real assets/alternative investments/private equity, mutual funds/passive investing/indexing, financial crises and financial market history, performance measurement <b>Key Findings</b> ▪ Allocation decisions for liquid alternatives can be simplified by focusing on their risk properties and extracting the return potential needed to justify a moderate allocation. ▪ All else equal, greater volatility or lower equity market correlation makes an alternative asset more attractive in terms of reducing the return threshold. ▪ By and large, liquid alternative funds have historically failed to clear the return thresholds implied by this framework.