Specifically, we examine two approaches:

1. Introducing an equity call overlay to give asymmetric upside exposure to equities to avoid underperforming the YFYS Other benchmark during periods of strong equity performance; and
2. Using a building blocks approach to combine beta and alpha from different sources, allowing us to “port” alpha from liquid alternatives into existing equity, fixed income or other asset allocations.

We believe our Liquid Alternatives Balanced Fund can provide investors with a reliable source of diversification. The live track record has only been less than two months, but from launch on 14 July 2022 to the end of August, the fund is up 1.8%. YTD pre-live performance has been +11.0%, highlighting the diversification qualities during a very difficult period of performance for both equities and fixed income. The table below shows how low – in many instances negative – correlations are between our Liquid Alternatives Balanced Fund and other asset classes over different time periods.

Figure 1: Liquid Alternatives Balanced Fund long term correlation to other asset classes

Consistent with the idea that a liquid alternatives investment is different to other asset classes, it would be classified under the “Other” asset class for Your Future Your Super benchmarking purposes. However, we consider the “Other” benchmark to be perhaps one of the more problematic benchmarks from an asset allocation perspective since investments which are clearly supposed to be different to equities and fixed income are nevertheless benchmarked against those asset classes (50/50 equity/fixed income). This introduces the additional risk for “Other” assets that the investment underperforms its benchmark purely because equity performance is exceptionally strong.

Earlier this year we explored exactly the same problem for commodities (see Reconciling commodities with YFYS ‘Other’ benchmark, May 2022) and outlined how the use of a systematic equity call overlay could hedge the risk of benchmark underperformance resulting from strong equity performance, without compromising too severely the diversification benefits of the intended investment. The same analysis holds true for liquid alternatives. The chart and table below show a back test of the call overlay and Liquid Alternative Balanced Fund compared to the YFYS Other benchmark. We can see, for example, that 2013 and 2014, years of very strong equity performance, the Liquid Alternatives Balanced Fund would have underperformed the YFYS benchmark by ~6.5% in both years. Introducing a call overlay to give asymmetric exposure to equities reduces that underperformance significantly.

Figure 2: Liquid Alternatives plus call overlay   Figure 3: Annual performance versus YFYS benchmark

We also consider a building blocks approach to combine beta and alpha exposures from different asset classes. For example, we can combine a passive equity investment and an appropriately sized allocation to our Liquid Alternatives Balanced Fund. An investment in the combination will look like equities, walk like equities and quack like equities. It makes sense to benchmark such an investment to… ducks?

To demonstrate the concept more concretely, we show below a backtest of a passive investment in Australian and International Equities and Fixed Income, with and without a 10% allocation to our Liquid Alternatives Balanced Strategy. The combined investment is the sum of the beta of the chosen benchmark and the alpha delivered by the absolute return of the fund. Apart from the outperformance, the lines track each other very closely, with a daily tracking error of just 37bp p.a.¹ and correlation to the benchmark above 0.99 in all instances.

Figure 4: Asset class beta Liquid Alternatives Alpha

We consider the building block approach outlined above to be conceptually no different to active vs passive investments in different asset classes. The combination has some (limited) tracking error to the relevant benchmark – but so too does an active investment – and the overall investment return profile will look very similar to the benchmark, again, no different to an active investment. The nice part of this approach is we are now able to source beta and alpha from different places. One key difference from an active investment is the fee proposition. For an active manager, investors pay a single (higher) fee, which effectively means they pay the same fee for both the beta and alpha they get from the manager. Under the building blocks approach, the investor only pays active fees for the alpha portion of the portfolio, with the beta part charged appropriately (ie a very low fee for a passive beta investment) making the overall fee materially lower.²

Another benefit, specific to our Liquid Alternatives Balanced Fund, is that we can run the strategy on both a funded and unfunded basis. Some betas are very easily accessible in unfunded form, others less so (eg fixed income). In such cases we can choose to fund the beta component and run the liquid alternatives component unfunded.

For investors looking for diversifying assets at the portfolio level, the call overlay may be more appealing. For others for whom the absolute return aspect is more important, combining liquid alts (or any other absolute return strategy) with existing or additional ‘beta’ allocations may make more sense. Afterall, usually the purpose of an absolute return strategy is simply to add alpha at the portfolio level, and such an approach will still achieve that objective.

The Solutions Team

The Solutions team provides derivative overlay and risk management fiduciary services to Asset Owners and Managers in Australia. Our goal is to provide asset owners and managers with an experienced overlay advisory and execution service to improve portfolio outcomes and cost efficiency.

1 The tracking error is the same in all examples because the difference is always the return from the same investment in our Liquid Alternatives Balance Fund.

2 Say fees on an active fund are 50bp. The fee on our Liquid Alternatives Balance Fund is also 50bp and assume a 5bp fee on passive beta. The overall fee for the beta + alpha building block approach is now 5bp * 1 + 50bp * 0.1 = 10bp, leading to a 40bp fee saving.

Important notice

Financial services provided by Challenger Investment Solutions Management Pty Ltd (ABN 63 130 035 353 AFSL 487354) (CIP Asset Management, CIPAM). The material in this document is general background information about Challenger’s Investment Solutions activities and is current at the date of this document. It is information given in summary form and does not purport to be complete. It is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any particular investor. These individual circumstances should be considered with professional advice when deciding if an investment is appropriate. Nothing in this document should be considered a solicitation, offer or invitation to buy, subscribe or sell any, or a recommendation of, financial products. All reasonable care has been taken to ensure that the facts stated and opinions given in this document are fair and accurate. To the maximum extent permitted by law, the recipient releases each member of the Challenger Limited group of companies, their directors, officers, employees, representatives and advisers from any liability (including, without limitation, in respect of direct, indirect or consequential loss or damage or loss or damage arising by negligence) arising in relation to any recipient relying on anything contained in or omitted from this document. Any forward looking statements included in this presentation involve subjective judgment and analysis and are subject to significant uncertainties, risks and contingencies, many of which are outside the control of, and are unknown to, Challenger. In particular, they speak only as of the date of these materials, and they are subject to significant regulatory, business, competitive and economic uncertainties and risks. Actual future events may vary materially from forward looking statements and assumptions on which those statements are based. Given these uncertainties, recipients are cautioned not to place undue reliance on such forward looking statements. Any past performance information provided in this presentation is not a reliable indication of future performance. This document is not audited.