Liquid alternatives offer investors the best hope of generating excess returns as interest rates linger at the high-water market, according to a new study by quant manager, AQR.
The report published in April edition of The Journal of Portfolio Management found most asset classes have historically struggled to rise above a “higher cash-rate tide”.
“All else equal, a higher cash rate would be good news for investors, because it would allow them to meet return objectives with a better-diversified portfolio,” the study authored by AQR European head of portfolio solutions group, Thomas Maloney, says. “But if history is any guide, all else isn’t equal. Equities and illiquid alternatives have tended to underperform when cash rates are higher. Bonds have done a better job of passing the cash rate on to investors, and liquid alternatives have done best of all.”
Titled ‘Honey, the Fed shrunk the equity premium: asset allocation in a higher-rate world’, the AQR analysis plots the performance of mainstream asset classes against almost a century of US interest rates to the end of last year.
During high-rate epochs the US equity risk premium above cash typically sinks to about half (or more) below the level achieved in low-rate environments.
The AQR study also examined a broader set of assets classes over the 33 years to the end of last year with similar results.
“Equities and credit follow the same pattern as before—much slimmer premiums when rates are higher—which is also clearly seen for private equity and real estate,” the report says. “Treasuries fared better during this sample, even earning a slightly higher premium from higher starting rates.”
However, liquid alternatives strategies – that balance relatively high cash (or the like) holdings with hedge fund techniques – proved the most resilient in high interest rate eras, the AQR analysis shows.
“Liquid alternatives’ sensitivities are particularly interesting,” the study says. “We chose equity market-neutral and trend-following strategies because both have exhibited near-zero equity beta over the long term, and both tend to maintain large cash holdings. They were able to generate comparable excess returns in both environments, so their average total returns were substantially higher in the higher-rate regimes: They delivered on their cash-plus objective.”
But AQR warns investors need to carefully watch fee schedules in liquid alternatives funds.
“Where cash-plus strategies charge performance fees, they should be on returns above a cash benchmark, just as long-only managers are evaluated against an appropriate market benchmark,” the report says.
The AQR boost for liquid alternatives comes with the usual caveat that market-timing “is difficult”.
“Long-term historical patterns don’t always persist, especially over shorter horizons,” the study says.
Either way, the AQR paper suggests persistent higher rates will undoubtedly make asset allocation more challenging for investors than in the recent past.
“… regardless of whether or how quickly rates fall, it’s almost certain that the average level of rates will be substantially higher over the next 5 to 10 years than it was during the past decade or the one before.”
Founded in 1998 by Cliff Asness, the quant-based AQR has more than US$100 billion under management including a convertible arbitrage fund mandate for the NZ Superannuation Fund.