Did Liquid Alternatives Pass the Stress Test?

Liquid alternatives are sold as strategies that improve portfolio diversification, especially when traditional stock and bond markets tank. Have they passed the test that markets have posed this year?

Liquid alternatives are one option for enhancing diversification. These mutual funds and exchange-traded funds offer exposure to strategies like long-short equity, merger arbitrage, and trend-following, which are designed to generate returns with low correlations to traditional stock and bond markets. But low correlation doesn’t guarantee positive performance during down markets. In this article, we look at how these strategies have held up during the recent market stress—and what that might mean for portfolio construction.

Equity Market-Neutral Has Been a Bright Spot

Exhibit 1 shows the average return during the recent drawdown for Morningstar Categories that feature common hedge fund strategies relative to US stocks and bonds. It also includes three-year annualized and risk-adjusted returns through April 8, 2025.

Equity market-neutral funds have led performance during the recent market selloff, returning an average of 1.58%—even outpacing US core bonds, which have held up relatively well. Morningstar’s Guide to Approaching Liquid Alternatives in 2025 emphasized the importance of assessing these hedge fund strategies’ diversification benefits. Equity market-neutral funds stand out for their low correlation to traditional asset classes like global equities (Exhibit 2). By taking roughly equal long and short positions, these funds aim to neutralize broad market exposure. While they still make active bets—using factors like value, momentum, or classic fundamental analysis to guide stock selection—their near-zero net equity exposure helps them remain resilient in volatile periods.

Systematic-trend funds, standouts in 2022, have been less effective recently. These strategies typically struggle when market trends reverse abruptly, such as the US dollar’s recent shift, or when markets lack clear direction. They tend to perform best in environments with sustained trends, such as rising interest rates in 2022, where they can take long or short positions to capture momentum.

Most other liquid alternatives have done worse than bonds in the recent turmoil but have lost less than US stocks. Their impact on a portfolio depends largely on whether an investor uses them as substitutes for stocks, bonds, or cash. Putting a slice of an equity allocation in the typical fund from any of the liquid alts categories would have tempered stock losses, but the average fund from all but the equity market-neutral group would have detracted from a bond portfolio in the recent market drop. Strategies like event-driven or multistrategy, with their relatively low volatility, may seem like attractive substitutes for core bonds, especially given their outperformance over the past three years. However, periods of market stress show that they do not always provide the same level of downside protection as high-quality fixed income, particularly with interest rates higher than they’ve been for most of the past 15 years.

Most Equity Market-Neutral Funds Have Positive Returns

There can be a wide dispersion of returns among hedge fund-like strategies. But within equity market-neutral, most funds have been able to generate positive returns. Exhibit 3 shows the percentage of funds in each category that have notched a positive return during the drawdown. The parentheses indicate the number of unique funds in each category.

There aren’t many relative value arbitrage funds, but most of them posted positive results in the downturn. These funds typically use a mix of arbitrage strategies that, for example, capitalize on pricing inefficiencies in mergers and convertible bonds.

No long-short equity, macro-trading, or systematic-trend funds rose in the period. Long-short equity and macro-trading typically have more net long market exposure, which leaves them more vulnerable to market crashes.

How to Think About Liquid Alternatives Now

A stressful stretch in the market is a good time to revisit your portfolio assumptions, including how each piece contributes to overall risk and return. It is not the time to overhaul your portfolio based on what worked last time. For example, investors who jumped into systematic-trend funds after their strong performance in 2022 have not seen the same results in this drawdown. Equity market-neutral funds have stood out this time but may not next time. Understanding why certain strategies perform the way they do in certain environments is better than chasing recent returns.

The goal is to build a portfolio in which each strategy serves a purpose across a range of market conditions. Liquid alternatives can be useful tools, but they require extra homework.