One word defines the investing landscape in early 2025: uncertainty. From inflation and economic growth to geopolitics, the range of possible outcomes is broad. In uncertain times, diversification remains one of the strongest defenses for portfolios.
To enhance diversification beyond traditional stocks and bonds, some investors and financial advisors may turn to liquid alternatives—hedge fund-like strategies, such as equity market-neutral investing and managed futures. These strategies gained popularity after the global financial crisis when investors sought tools that might have cushioned the impact of the 50% drop in the Morningstar US Markets Index and the 30% decline in a typical 60/40 balanced portfolio. However, the past 15 years have provided key lessons about liquid alternatives that investors should weigh before adding them to a portfolio.
Morningstar’s recently published Guide to Customizing a Model Portfolio outlines best practices for modifying existing models, covering topics like adding active strategies to passive models, risks of swapping bond funds, and the impact of cryptocurrencies. This article focuses on how to effectively integrate liquid alternatives into a portfolio. For more insights, join our upcoming webinar on March 25: Navigate Custom Model Portfolios With Morningstar Analysts.
Best Practice: Start With Diversification Benefits
Liquid alternatives encompass a wide range of strategies, each serving different roles in a portfolio. Before diving into fund selection, it’s crucial to define the problem you’re trying to solve. Recent years have provided plenty of examples of when liquid alternative strategies could have contributed to a portfolio, but these scenarios are always easier to see in hindsight than looking ahead.
- In 2020 and early 2021, with interest rates near record lows, liquid alternatives with low volatility and no correlation to interest rates could have helped as potential bond diversifiers.
- Strategies like systematic trend-following can shine and provide much needed support when stocks and bonds decline together, as seen in 2022.
- In 2025, with bond yields at their highest levels since the global financial crisis and US stocks trading at historically high valuations, alternatives that reduce stock risk may be more compelling.
To help investors assess diversification benefits, the Morningstar Style Box for Alternative Funds provides a clear visual of how different liquid alternatives compare. It measures strategies against global stocks—the riskiest part of many portfolios—to help fine-tune selection. Exhibit 1 shows each liquid alternative category’s median correlation and volatility relative to the Morningstar Global Markets Index.
Among liquid alternative strategies, systematic trend and equity market-neutral stand out for their strong diversification benefits relative to global equities—though they come with distinct volatility profiles:
- Equity market-neutral, with its low volatility, can act as a bond substitute, offering stability without heavy stock market exposure.
- Systematic trend, on the other hand, carries higher volatility, making it a better fit as a stock replacement for those looking to hedge against stock market downturns.
- Long-short equity strategies, by design, maintain a net long stock position (typically approximately 50%), making them the most correlated to equities. While they won’t eliminate stock market risk, they can help smooth portfolio volatility.
- Multistrategy funds combine multiple liquid alternative approaches, offering a one-stop shop for diversification. Their flexibility, as shown in Exhibit 2, allows them to deliver a wide range of risk-reduction benefits.
Before allocating to a liquid alternative fund, it’s essential to understand the specific type of diversification it provides—not all strategies offer the same benefits.
Don’t Assume All Funds in a Category Perform Similarly
Even within the same liquid alternative category, performance among individual strategies can vary significantly. In comparison to traditional categories such as Morningstar Large Blend, Intermediate-Core Bond, or Moderate Allocation, liquid alternatives often show a much wider range of returns.
Exhibit 3 highlights this dispersion by showing the standard deviation of three-year annualized returns across different categories. Standard deviation measures how much individual fund returns deviate from the average—the higher the standard deviation, the greater the performance variability within the category.
Nearly all liquid alternative categories have shown a wider range of returns over the past three years compared with traditional categories—with event-driven strategies being the only exception. This underscores a key challenge for investors: It’s not just about choosing the right category but also selecting the right fund.
A poor choice can be more costly in liquid alternatives than in traditional asset classes. For example, over the past three years, the performance gap between the top and bottom quartile of long-short equity funds was around 5 percentage points—roughly double the gap in large blend funds.
Picking the Right Fund Matters More in Liquid Alternatives
Manager selection is especially critical when looking at the lifespan of many liquid alternative strategies. Short periods of weak performance can mean a fund won’t be around much longer.
Since 2014, more than 250 liquid alternative funds have been merged into another fund or liquidated altogether. Today, investors have about 160 liquid alternative funds to choose from—excluding the Morningstar digital assets category, which falls outside the scope of this article.
Exhibit 4 illustrates the number of liquid alternative funds available today versus those shut down over the past decade.
Assess a Firm’s Commitment Before Investing
When evaluating liquid alternative funds, a firm’s track record of launching and closing products matters. A history of frequent fund closures may signal a lack of long-term commitment—something investors should consider before investing.
One firm that has demonstrated resilience is AQR, which has stuck with its strategies even through challenging periods. Exhibit 5 illustrates this by comparing the growth of a $10,000 investment in AQR Style Premia Alternative QSPIX—a market-neutral multistrategy fund—against a globally diversified 60/40 balanced portfolio, represented by Vanguard LifeStrategy Moderate Growth VSMGX.
AQR Style Premia Alternative started strong, but from February 2018 to October 2020, the value factor in the global equity strategy declined. Initially, this happened alongside losses in the momentum factor, which usually moves in the opposite direction. Later, the value factor’s losses outweighed gains in the rest of the portfolio. The strategy suffered—enduring a three-year, 40% drawdown while traditional long-only portfolios, like a global 60/40 mix, thrived.
Most asset managers would have abandoned ship, but AQR stayed the course, refining its process over time. Investors who weathered the prolonged drawdown—or simply avoided checking their accounts too often—were ultimately rewarded with exceptional long-term returns for an uncorrelated liquid alternative strategy.
Take a Long-Term View on Liquid Alternative Strategies
AQR Style Premia’s experience isn’t unique. Any liquid alternative strategy designed for diversification may lag when stocks and bonds are performing well. Investors need to be patient and recognize that low-correlation strategies have unique performance patterns in different market conditions.
Take systematic trend following, for example—it was the top-performing liquid alternative category in 2022, a year when traditional 60/40 portfolios struggled.
From 2015 through 2021, the systematic trend category significantly underperformed compared with a US 60/40 portfolio. But when inflation surged and both stocks and bonds declined in 2022, systematic trend strategies delivered on their diversification promise.
The problem? Most investors missed out. Frustrated by years of underperformance, many abandoned these strategies too soon, exiting before the payoff arrived. That’s the challenge with diversification—by design, part of your portfolio will always be underperforming.
Don’t Assume Every Portfolio Needs Liquid Alternatives
Investing in liquid alternatives isn’t for everyone. These strategies tend to be more complex, more expensive, and less predictable when they’re uncorrelated to major markets. While some funds have proved their ability to enhance risk-adjusted returns, many have failed to meet that goal.
For those interested in liquid alternatives, following the best practices outlined in this article can help ensure a more informed approach.