Liquid Alternatives at Work

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GMO’s liquid alternatives are hedge fund strategies (e.g., equity long-short, global macro, event-driven) managed with an emphasis on risk control and liquidity. The GMO Alternative Allocation Strategy (“ALTA”) is a liquid alternative solution combining several underlying strategies; ALTA is available in a mutual fund with daily liquidity.

Liquid alternatives are a tool for your portfolio. Maximum effectiveness can be realized by deploying them smartly to achieve specific objectives. While they provide diversifying returns, liquid alts also serve as a source of dry powder in dynamic allocations that meaningfully vary weights with the market environment. In this use case, daily liquidity is not merely an operational detail—it is a strategic advantage and can actually facilitate higher total portfolio returns. In 2022, GMO’s outsized allocation to liquid alternatives ¹ within our unconstrained Benchmark-Free Allocation Strategy ²  helped to protect capital during the drawdown and facilitated portfolio rotation by taking advantage of changes in valuations.

From Defensive Positioning to Opportunistic Reallocation

Entering 2022, GMO’s multi-asset portfolios were defensively positioned as we believed stocks and bonds were extremely expensive. ³ At the time, Benchmark-Free held no Treasuries, less than 30% in stocks, and allocated over 60% to liquid alts. As stocks sold off, ⁴  risky assets became cheaper. Benchmark-Free’s liquid alts portfolio held up well, with positive returns and low volatility. We actively drew down our liquid alts allocation to fund the purchase of 23 percentage points of stock and credit over the course of the year, materially changing Benchmark-Free’s exposure to risky assets.

LIQUID ALTS PROVIDED DRY POWDER TO REALLOCATE

GMO Benchmark-Free added 23% to risky assets sourced from liquid alts in 2022

As of 12/31/2022 I Source: GMO
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The features of our liquid alts allocation worked together to manifest this result: 

• Positive Return—Tapping into multiple return drivers, our liquid alts portfolio was able to deliver a positive return when it was desperately needed.
• Diversification—Because liquid alts have virtually no equity beta or duration exposure, they were able to deliver when stocks and bonds both suffered double-digit drawdowns.
• Liquidity—Daily liquidity facilitated our seamless, incremental rotation out of alternatives, allowing us to purchase newly cheaper stocks and credit, and thus benefit from a strong equity rebound.

Preparing the Portfolio for Potential Risks

Liquid alternatives were critical for GMO's Benchmark-Free Strategy in 2022, a rare period where both stocks and bonds experienced major drawdowns. Could we face a similar drawdown in the future?

A number of scenarios could be particularly damaging for risk assets: selling pressure from a deluge of IPO shares coming off lockup; an AI boom that falls short of elevated growth and profit expectations; or some combination of either path with persistent inflation that drives real rates higher and pressures both stocks and bonds.

We believe today’s wide range of plausible macro outcomes warrants the inclusion of diversifying assets in portfolios. While GMO's liquid alternatives are not designed to be consistently negatively correlated to equities, several of our largest risk allocations within our Alternative Allocation Strategy ⁵  could potentially benefit from an AI-driven unwind. Our Equity Dislocation and World Market Neutral strategies maintain short exposure to some of the market's most speculative AI-related areas and have historically performed well during periods when enthusiasm surrounding these themes has softened. Long-Short Quality shares many of these characteristics through its preference for higher-quality, more defensively positioned businesses, while our Global Macro strategies currently maintain a net short equity stance.

Together, these exposures could provide valuable diversification and a potential source of liquidity precisely when many traditional assets are under pressure, creating opportunities to rebalance into attractively priced risk assets following a market correction. Liquid alternatives aren’t insurance, but they may be capable of generating positive returns through the cycle and performing independently from stocks and bonds, which could help in a macro tail event.

Conclusion

GMO’s Asset Allocation team has used liquid diversifying strategies in portfolio construction for more than 25 years. That experience is reflected in Benchmark-Free, where liquid alts have been a critical component of the strategy’s ability to deliver equity-like returns with roughly half the volatility since inception. By providing attractive returns, consistent diversification, and liquidity, we believe a liquid alternatives allocation can help investors preserve flexibility and capitalize on opportunities during periods of market stress.