Institutional investors’ thinking about risk allocation has been dominated for some time by traditional beta sources, mainly long exposure to equities and bonds.
The market regime provided little reason for radical change. After all, for two decades, stock and bond returns were negatively correlated, enabling 60/40 equity/bond mixes to deliver both a risk-balanced allocation framework and attractive returns.
That world changed abruptly with the market setbacks of 2022, as both asset classes endured major selloffs—leaving investors less confident that a simple equity/bond mix can provide effective diversification. And with a very different market regime in place, they can't expect these asset classes to reprise their bull market real returns, either. As a result, alternative return streams are likely to feature more prominently in strategic asset-allocation discussions.
But the world of alternative strategies has been evolving fast in recent years, so before considering an enhanced allocation to alternatives, it's critical for investors to understand those changes and their implications for portfolio design. Here, we'll highlight several developments for systematic alternative strategies, identify three ways for investors to avoid crowded trades where returns are becoming more challenged and instead identify areas with more return potential.
Long-Term Signals Becoming Less Effective as Markets Grow More Efficient
Advances in computing power, analytical speed and automated trading are eroding the profitability of well-known longer-term strategies. Information is increasingly becoming available, and the market can price it into assets faster.
Valuation anomalies are being recognized and priced into markets much quicker, with information advantages eliminated much sooner. Strategies with longer-term investment horizons are becoming less effective than strategies focused on short-term anomalies. Investors need to recognize this trend, adapt to have a healthy mix of longer and shorter time-horizon strategies, and seek more evolved, systematic strategies where information advantages aren't so readily competed away.
For instance, a corporate event-driven strategy seeks to profit from a firm's changes or announcements that aren't fully priced by the market immediately. One classic example is earnings surprise—holding shares of companies that have had positive surprises. This strategy used to be profitable for holding periods of up to three months, but the time period before stocks fully incorporated earnings surprise dwindled until the strategy became ineffective. A number of similar but lesser-known or commoditized strategies are still profitable. However, to benefit from these anomalies, investors need a systematic process that can capture and react to announcements very quickly—even so, we've seen holding periods shrink from weeks to days. These examples also emphasize the need for efficient trading and execution platforms that enable fast, cheap execution.
This post is funded by AllianceBernstein
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