CAIA essay: liquid alternatives are easier to justify than hold

Liquid alternatives are easier to justify in theory than to own, and that gap is where allocations go wrong, according to an essay the CAIA Association published on Oct. 15.

The essay, by John W. Moore, CFA, CAIA, CMT, of Stratview Wealth Management, calls the problem the "Perspective Premium." It is "not a measure of expected or additional returns," he writes. Instead, it is a thought exercise built on the idea that some strategies need more discipline than others to realize their intended value across market cycles.

For allocators, the essay turns that discipline into a pre-funding document: how the strategy is expected to make money, when it can struggle, and what would count as evidence the thesis is changing. Answered in advance, those three questions become the reference point for later reviews, when a liquid alternative sleeve may be underperforming more familiar holdings.

The essay begins with the tension: liquid alternatives offer different sources of return, different responses to market environments and different potential contributions to a portfolio. Those differences are also what make the strategies harder to understand, since they rest on more complicated combinations of return drivers, portfolio construction and risk exposures than long-only funds. Sourcing and sizing an allocation inside a larger portfolio is a second difficulty.

The liquid alternative wrapper sharpens the problem. These strategies sit in vehicles that are priced and traded far more often than the private funds beside them, so the option to sell is open on the day discomfort peaks. The essay's suggestion is that the hold-or-sell decision be made against a written thesis rather than the most recent stretch of relative performance.

Moore is careful about the failure mode of his own argument. "Some strategies legitimately fail to deliver on their objectives," he writes, and new information can warrant a change in conviction. The framework is meant to improve decision quality, he says, not to encourage holding for the sake of patience.

A manager who can name in writing the conditions under which the strategy struggles, and the evidence that would end the thesis, gives an allocator something to monitor against. A sleeve with no such statement leaves recent relative returns as the only available test — the circumstance the essay identifies as the hardest one to hold through.