As liquidity tide recedes, will investors need a different boat?

Alternative investments can include a variety of investment vehicles, such as private equity, real estate, commodities, hedge funds and even ‘liquid alternative mutual funds’.

There has often been a relatively low correlation between alternative investments and traditional stocks and bonds, and investors typically add them to their portfolios in order to diversify, enhance returns or reduce risk.

More specifically, traditional hedge funds have historically had a reputation of being opaque, illiquid and having a high fee structure. Liquid alternatives, however, are multi manager and multi strategy hedge funds that are priced daily, offer full transparency and have lower costs. The availability of these has expanded rapidly over the past decade, and there are Luxembourg domiciled UCIT liquid alternative products available for investors to consider. The post-2008 expansion of the Fed’s balance sheet from $900 billion (Dh3.3 billion) to nearly $4.3 trillion today has been one of the most dominant market shaping forces over the last decade.

It has created a massive tide of liquidity that lifted assets across the globe — in some instances indiscriminately — while influencing investor behaviour. In addition to yields being driven toward record lows and stock markets to record highs, many investors migrated toward riskier assets while the cost of capital was kept artificially suppressed. We believe this dynamic is about to change. The tide appears to be receding.

Challenges

While the Federal Reserve has already embarked on its journey towards rate normalisation, other major central banks around the world also started unwinding in 2018, with many striking increasingly hawkish tones.

Investors who are not prepared for this shift from the recovery era of monetary accommodation to the expansionary post-quantitative easing era may be exposed to significant risks, in our view. Markets could see increased volatility and sharp corrections, recalling for example the magnitude and speed of adjustments in US Treasury (UST) yields that began during the fourth quarter of 2016 and continue today.

Consequently, a challenge for investors will be that the traditional, diversifying relationship between bonds and risk assets that investors expect may not hold true in this new era, particularly if we experience the cycle of UST declines we are experiencing. It’s quite possible to see risk assets also decline as the ‘risk-free’ rate (yield on USTs) ratchets higher. Markets have become accustomed to exceptionally low discount rates — a shift higher would materially impact how those valuations are calculated.

Additionally, a sense of complacency has developed across the asset classes as UST returns and risk-asset returns have often had positive correlations. However, as monetary accommodation unwinds, those positive correlations could continue but with the opposite effect — simultaneous declines across bonds, equities and global risk assets as we exit an unprecedented era of financial market distortions.

Flexible alternatives

Looking towards 2019, investors should continue to explore investing in the flexibility and convenience of mutual funds, while also enjoying additional benefits of alternative investments to reach their longer-term asset growth goals. The liquid alternatives asset class has grown significantly in recent years. In 2017, the space grew $96 billion and has grown an additional $20 billion in 2018, till August 31).

The bottom line is that we believe the massive tide of low-cost money that lifted all boats and allowed for carefree sailing is receding. Investors who are not prepared for this change may be exposed to significant risks. Perhaps it’s time to look to add other boats to one’s portfolio, crafts better suited to navigating the sandbars, rocks and muddy waters that we believe will likely surface in the coming quarters.

■ Dhiraj Rai is director, Gulf and Eastern Mediterranean, Franklin Templeton Investments (ME) Ltd.