Like all Federal Reserve chairmen, Ben Bernanke maintains a good poker face. But privately, like millions of investors, he must be elated with the stock market’s rally to record highs. The Fed’s policies, after all, were intended to boost asset prices, revive risk appetites and stimulate the wealth effect – all in the hope of generating a self-sustaining recovery.

Yet even if this occurs – and we hope it does – the major developed economies will continue to face headwinds that will stunt longer-term financial market returns for years to come. Swelling debt, tightening regulation and ageing populations will continue to drive the “new normal”, the macroeconomic dynamic we labelled in May 2009, which anticipates a prolonged period of sub-par growth.

Increasingly, these trends will drive investors to non-traditional and highly active strategies with potential for incremental alpha and returns uncorrelated with traditional stocks and bonds. New sources of diversifying financial betas, including currency, commodity and volatility, will grow more common in portfolios. Strategies dependent on high degrees of manager discretion, such as market-neutral and long/short equity, will aid diversification and offer potential downside risk mitigation.

To compete, investment managers will need to help investors think alternatively about risk and reward objectives. Managers will need deeper and more diverse talent, global presence and a flexible yet intellectually rigorous process of analysis and decision making. They also will have to offer alternative strategies in mutual funds and other liquid structures that an array of institutional and individual investors can access easily.

Hyper-stimulative monetary policies in the US and elsewhere have helped the Dow Jones Industrial Average double over the past four years, yet it is unclear whether job creation and economic growth will take off. Investors should consider how a sustained period of low growth would affect the maths of security valuation.

Distilled down to basics, financial prices are a function of terminal values of an asset at a specified future date, cash flows and discount rates. The market value of every security ultimately reflects the future cash flows investors expect the underlying asset or enterprise to generate. These flows, coupled with an expected terminal value, are then discounted at a risk-adjusted rate to determine present value.

Amid low growth, however, the scope for inflation-adjusted terminal values and cash flows to surprise on the upside would be limited. Today’s exceptionally low interest, and hence discount, rates have already increased the present value of expected cash flows. Thus, the outlook suggests that returns from financial betas – indeed, all betas across all asset classes – will probably remain below their historical norms.

That admittedly sober outlook explains why “liquid alternatives” have become the latest investment trend. Broadly, we define these as highly active investment strategies exposed to non-traditional betas that are uncorrelated to traditional stock and bond returns; unconstrained by benchmarks, they may use shorting and other tactical approaches to risk exposures, sometimes with the intent to limit downside risk.

Importantly, liquid alternatives can be bought and sold as mutual funds, making them accessible to a broad range of investors who would generally not have access to, or an appetite for, the traditional private alternatives market.

As investors migrate to liquid alternatives, demand may fall for active managers who add little value.

To compete, asset managers will be required to demonstrate strengths in the following areas:

Global reach. Superior return opportunities will not be localised to one market or geography.

Investment process. Managers will need to demonstrate intellectually rigorous analysis and decision making.

Flexibility. Managers will need to rethink traditional asset class definitions and reconceptualise risk and return boundaries.

Risk management. Liquid alternatives demand rigour and focus.

In an era of low beta returns, active managers that can produce consistent, high quality, liquid and diversifying returns in easily accessed structures will be best able to help investors achieve their goals. It is time to think alternatively.

Douglas M Hodge is chief operating officer of Pimco

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