Liquid Alternatives Feel More Fluid to New Investors

Investors Seek Greater Flexibility With Alternative Funds

A relatively new group of innovative and controversial investment products has grasped the attention of the average investor. They allow these investors a chance to use investment strategies that were previously only accessible to accredited investors through private fund structures.

These products are known as liquid alternatives, or “liquid alt,” and their popularity is surging. While some experts support the introduction of these alternative funds, others worry that its speed of innovation is moving faster than the speed of investor education.

What Is a Liquid Alternative Investment, Exactly?

According to the Financial Industry Regulatory Authority (FINRA), there is no single definition of liquid alt investments. The category can vary widely but typically includes publicly available investments such as mutual funds, hedge funds, ETFs, real estate, commodities, ETFs, start-ups, and distressed debt. They are called “liquid” because investors can generally trade in and out of them with flexibility, unlike more rigid hedge funds.

A Primer to Liquid Alternatives

Liquid alternative investments, also known as alternative mutual funds and ‘40 Act Funds, are usually comprised of mutual funds and exchange-traded funds that incorporate some successful hedge fund strategies. These strategies include global macro, long-short equity, and managed futures.

The funds are registered under the Investment Company Act of 1940, which instructs portfolio managers to provide daily liquidity, estimate daily net asset value, and narrow the use of leverage and short selling.

Liquid alternative investment funds offer low-risk-adjusted returns that are not correlated to traditional investments or benchmarks and offer more downside protection. This is because alternative strategies have been designed to maintain a low beta, which can make them less sensitive to certain market conditions. The benefits of alternatives are meant to be felt over the long term, according to Goldman Sachs Asset Management.

The 2008 Financial Crisis and the Launch of Liquid Alts

During the 2008 financial crisis, people wanted to liquidate or rebalance the assets in their portfolios, but investors with traditional assets were constrained by lockups and restrictions. In addition, investment scandals like the Bernie Madoff fraud, which robbed investors of billions of dollars, and the regulatory scrutiny of hedge funds ignited fears and raised concerns.

Diversification, Transparency, and Regulatory Oversight

As a result, investors sought alternative investments that offered diversification through low correlation, increased oversight, and improved risk mitigation. Investor demands for daily liquidity and transparency increased, and they wanted to have the ability to sell off or shift investments around when needed. This transformed alternative funds and paved the way for liquid alternative investments.

Liquid alt funds flourished in the decade after 2008, reaching a total worth of $255 billion in the U.S. by 2022, and Canada’s market surpassed $21 billion in 2021.

Liquid Alternatives Offer Broad Appeal to a Broader Audience

Liquid alternatives initially appealed to institutional investors and individuals with high net worth, especially those who wanted hedge fund managers to adjust the transparency, fees, and lockup periods for hedge funds. Now, a broad range of investors can benefit.

According to Charles Schwab, liquid alternative ETFs “attract investors of all sizes, not just those with ‘accredited’ or ‘qualified’ status, as long as they meet the same regulatory standards as other public funds.”

With the liquid alternative market having boomed so quickly, what do the experts have to say about its future?

Liquid Alternatives in a Post-Pandemic Market

Some experts still consider liquid alternative funds to be a good investment for sophisticated investors but advise inexperienced investors to acquire more education and assistance from skilled managers.

Like any investment, the performance of liquid alts can fluctuate and there are pros and cons.

Dr. Sushil Wadhwani, CBE, Chief Investment Officer of PGIM Wadhwani believes liquid alts will help offset the challenges posed by the risks of recession. With interest rate hikes slowing down, Wadhwani said, “We believe that the last stages of this tightening cycle could generate significant opportunity for liquid alt strategies for the balance of 2023 and beyond.”

Some experts are more skeptical, calling the liquid alternative investment “a watered-down hedge fund,” citing the illiquidity premium, since liquid alternative investments generally have lower returns than traditional hedge funds, even when following a similar strategy.

Illiquidity Strategy Doesn’t Flow, Some Argue

Not all experts agree with the above sentiments. Although an illiquidity premium occurs in certain strategies, an article in Chief Investment Officer indicated that “many traditional hedge funds may not have the suggested advantageous exposure to illiquid holdings that critics assume.”

Based on their analysis of a sample of funds, the researchers observed that “liquid alternatives actually outperformed traditional hedge funds over the historical one-, three- and five-year periods.” While there is still more long-term research needed, the study noted that “it is important to distinguish fact from mere perception” in the case of the illiquidity premium.

Most experts offer caution, noting that liquid alternatives are best for investors with insight, time to research, high risk tolerance, and the ability to weather the short-term volatility of these investments – all while being aware of the potential for underperformance.

New Strategies Forming for Liquid Alts

Not all hedge fund strategies can be replicated in liquid form. Liquid alternatives categories haven’t been well-established, and they are evolving, so hedge fund categories haven’t translated clearly.

Liquid alternatives also lack performance benchmarks, and since they’ve been designed to perform well based on a particular strategy, it’s hard to evaluate them. They’re still in the nascent stage, without long track records. More time is needed to evaluate performance under certain market stressors.

As these funds evolve, their strategies will become more complex, making it a challenge to keep investors informed, as was noted during the SIFMA Complex Products Forum in 2015.

However, now that we are 15 years in, track records are developing. It is possible that as experienced alternatives managers continue to pursue liquid alternatives, their level of knowledge and expertise will progressively improve.

More experienced managers will be a good thing since, for the average investor, Morningstar says liquid alternative funds “belong on the too-hard pile.”

With an experienced manager, some experts believe there is still a place for liquid alternative investments in investor portfolios.

Dr. Wadhawani of PGIM said that “on average, most investors are still not diversified enough in their portfolios,” noting that current market conditions might offer an opportunity for liquid alternative strategies in 2023.

Mark J. Gilbert, President of Reason Financial Advisors, said, “[2022] performance results are encouraging enough for [managers] to take another look at using liquid alts in diversified client portfolios.”

Lastly, Champs stressed complete and accurate disclosures written in clear and concise English so investors can be well-informed. The SEC has been conducting a nationwide sweep of liquid alternatives and their sponsors to ensure they’re legally compliant with the 1940 Act.

Diversity: Liquid Alternatives Grow, Traditional Models Evolve

Meanwhile, some experts have noticed a few trends, such as the increasing amount of management companies launching vehicles, as well as the involvement of different managers.

“Many ‘traditional’ mutual fund organizations have jumped into the fray, and some hedge fund managers have initiated liquid alt vehicles as well,” said Dr. Norman Mains, author of “Winning with Liquid Alternatives.” As far as the future of these alternative funds, many investors are looking at how the investments will sustain a market correction, said Josh Charlson of Morningstar. “When the time comes and there’s a significant downturn, they will need to do what they say they were supposed to do.”

“Liquid alternatives are a diverse group,” said Mains, “While almost all investors can improve their portfolios with allocation to some of the vehicles, they are not an “all-encompassing” investment solution.” Like any investment, alternatives cannot be expected to outperform markets routinely.

Know Your Goals and Speak With a Trusted Advisor

In the meantime, investors considering liquid alternatives need to establish their objectives so that their strategies match their desired outcome. Pay attention to long track records and discover historical risk and return characteristics to determine what drives returns in different market conditions.

Most importantly, investors should work with experienced managers who are aware of the 1940 Act. One way they can narrow their search is by analyzing the manager’s track record for executing successful strategies.

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This is an updated version of an article originally published on January 7, 2015, and revised on December 19, 2019.]

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