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Investors And Liquid Alternatives: Taking Another Look

Guillaume Chatain, 13 March 2020

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This news service recently stirred the pot of controversy with an article casting doubt on the benefits of so-called "liquid alternatives" - such as funds offering daily liquidity but holding underlying assets that promise the kind of returns associated with hedge funds or private equity. Here's a response.

On 18 February this publication carried a guest article, "How Investors Should Think About Liquid Alternatives", by Christian Armbruester, chief investment officer at Blu Family Office. The article has prompted some pushback. Here, Guillaume Chatain, former managing director and head of equities at JP Morgan private bank in Asia, and founder and CEO of ResonanceX, a fintech firm. ResonanceX concentrates on bringing efficiencies and transparency to structured products and alternative investment.

The editors of this news service are pleased that a debate is taking place on this topic. We are grateful to Mr Chatain for his contribution; the usual editorial disclaimers apply.  Email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

In a world where investors buy bonds for capital appreciation... and (as Citi Private bank suggested) invest in equities for yield, other high yielding instruments are providing significant diversification and enabling to improve the efficient frontier of most portfolios. And I’d like to make the case for defined outcome investing that is offered by "ill-famed" structured products.

Many will rightly roll their eyes when reading these lines, as they remember the scandals over products which have been sold in the past as “ultra-safe” by advisors who often didn’t fully understand them. But more recently the industry represented by issuers and distributors has been forced to learn from its mistakes by regulators and is now required to sell these products with much greater transparency, especially with regards to risk and fees embedded in each product.

So why does it matter now?
Following market stability and rally induced by central banks having reversed balance sheet normalisation policy last year, with the Fed in turbo expansion mode at the end of 2019, and having created one of the most accommodative global monetary conditions on record, we are now witnessing a shift in sentiment.

Having just lived through the fastest S&P 500 market decline from an all-time high in history in the last two weeks, one can wonder if investors and traders mood will remain in a buy-the-dip mentality as they have been conditioned to believe that central banks will come to the rescue, again and again, to suppress volatility and keep market prices elevated. Or will investors shift their mindset and start to look at ways to protect the downside and/or look for ways to add convexity in their portfolios…that is what I would put in layman terms: find ways to be less exposed to the downside provided by the market, while being able to capture a big chunk of the potential upside.

While this is typically achieved by using combinations of options via listed and OTC markets, these levered strategies are complex to put in place and require expertise, active management and careful monitoring because the clock works against you when you purchase options.

And this is where structured products, a carefully crafted combination of bonds and derivative instruments packaged into a security have the potential to help most investors add optionality in their portfolios. These products provide some sort of convexity, enabling investors to build protection or buffers while receiving upside participation or coupons, and giving away the higher returns they don’t expect.

Taking advantage of higher volatility regime.
As I’m writing this article, markets have been in disarray with the S&P 500 losing at some point more than 15 per cent from the February highs, and the VIX –a gauge of forward-looking short-term volatility, and a barometer for risk appetite – shooting-up from 15 to 50 in just a few days due to fears about lack of coronavirus containment. And this is a good environment for structured products which are mostly sellers of volatility through options that are embedded in their payoffs, enabling investors to take advantage of deeper buffers and/or higher yield than they would have received in very smooth markets.

To give an example, as of last Friday you could buy a product paying an annual coupon of 6 per cent with downside protection as long as the S&P 500 trades above 70 per cent of its current level three years from now. As of Monday morning, as S&P futures are 5 per cent in the red, the coupon is now close to 8 per cent per year.

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