Persistent interest rate volatility has made even a balanced 60/40 portfolio a bumpy ride for investors so far in 2025. Volatility in equity and fixed income markets are well above long-term average levels (see chart). As investors continue to grapple with policy uncertainty and sift through its growth, inflation and deficit impacts, interest rate volatility in particular is likely to remain elevated.

During moments when volatility is elevated and correlations are positive across public markets, it is crucial for investors to look to other forms of diversification. Unlike other alternatives with a long delay before capital is deployed, liquid alternative strategies offer quick diversification. Liquid alternative strategies can provide capital preservation and potential gains during volatile markets.

What are “liquid alts”?

Liquid alternatives, or "liquid alts," are investment strategies designed to provide diversification and risk management benefits similar to hedge funds, but in a more accessible, liquid format. They combine the accessibility of mutual funds with sophisticated strategies to manage risk and go after the opportunities that volatility in financial markets can present.

In periods of market uncertainty, the capacity to tactically adjust a portfolio's exposure is invaluable. By incorporating hedging and tactical asset allocation, these investments can help smoothen returns and mitigate overall portfolio risk. Research by Morningstar found that liquid alternatives demonstrated resilience during the 2022 60/40 market downturn, with many strategies outperforming traditional equity and bond indices¹.

What are fixed income “liquid alts”?

During times of interest rate volatility, traditional fixed income investments may experience pronounced price swings. Liquid alts focused on fixed income employ a variety of strategies to earn alpha in ways that are uncorrelated with the broader fixed income market:

• Actively managed interest rate exposure: Shortening duration can protect against rising rates, while extending duration can capture gains when rates fall. In periods of higher volatility, some strategies can maintain a near-zero duration when appropriate.
• Broad investable opportunity set: Liquid alts strategies can invest across a wide range of global fixed income markets and multiple sectors. This flexibility allows them to capture alpha in less-explored parts of the market. These can include derivatives such as credit default swaps and niche areas of markets such as securitized credit that are not widely covered by analysts.
• Strategic credit allocation: Managers can dynamically shift between investment-grade, high-yield and structured credit based on where they see value, without the constraint of needing to follow a particular benchmark. Unconstrained liquid alts can add to specific qualities, sectors, or maturities where they see the opportunity to generate returns.
• Hedging: Strategies employ hedging to limit their exposure as part of a disciplined approach to risk management. This can include dedicated short positions (to limit volatility and drawdown) as well as a strategic allocation to cash (to be deployed when volatility creates opportunities for alpha generation).

Quality liquid alts strategies allow investors to swiftly adjust their risk exposure, while managing volatility and enhancing diversification. This makes them a valuable stepping stone out of traditional markets and towards a greater long-term allocation to private market alternatives.

¹ “Alternative Funds Are Winners in 2022”, 8 December 2022.

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