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Liquid Alternatives Feel More Fluid to New Investors

[Editor’s Note: This article was first published in Jan. 2015. Updated in Sept. 2017]

Liquid Investments Feel More Fluid

A new group of innovative and controversial investment products has grasped the attention of the average investor. They allow these investors the chance to use investment strategies that were previously only accessible to accredited investors through private fund structures. These products are known as ‘liquid alternatives‘ and their popularity is surging. While some experts support the introduction of these investment vehicles, others worry that its speed of innovation is moving faster than the speed of investor education.

During the financial crisis, people either wanted to liquidate or re-balance 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 out of billions of dollars, and the regulatory scrutiny of hedge funds ignited fears and raised concerns.

Is the speed of innovation moving faster than the speed of investor education?

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

A Primer to Liquid Alts

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. (Managed futures are often misunderstood. Why? Read more here.)

The funds are registered under the Investment Act of 1940, which instructs portfolio managers to provide daily liquidity, estimate daily net asset value and to narrow the use of leverage and short selling. They offer low risk-adjusted returns that are not correlated to traditional investments or benchmarks, and they 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, said Alan Hess, a research associate with Strategic Insight.

The benefits of alternatives are meant to be felt over the long-term

Liquid alternatives went through a growth spurt in 2013, wrote Josh Charlson, Director of Manager Research Alternative Strategies at Morningstar in the Alternative Investments Observer. “There were 70 distinct new fund launches, $40.3 billion in net inflows, and year end net assets of $139.3 billion–all new records,” he said. Assets in liquid alternatives have more than doubled since 2008, according to Strategic Insight’s 2013 press statement. In the third quarter of 2014, alternative mutual funds had nearly $300 billion in assets. If the “knowledge gap” were closed liquid alternatives could produce $2 trillion in assets under management within four to 10 years, the Chartered Alternative Investment Analyst Association shared on its website.

A Broad Appeal for a Broader Audience

Liquid alternatives initially appealed to institutional investors and high net worth individuals, 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.

Some experts consider them a good investment, especially for sophisticated investors; and, they suggest inexperienced investors acquire more education and assistance from skilled managers.

Other experts are skeptics, suggesting that liquid investments are watered down versions of hedge funds.  “Our view is that while liquid alts will offer investors some diversification benefits, mandated liquidity constraints will ultimately lead them to be significantly watered down version of true alternative funds,” said PricewaterhouseCoppers (PwC) in its June 2014 regulatory brief. However, other experts disagree.

Illiquidity Strategy Doesn’t Flow, Some Argue

Although an illiquidity premium occurs in certain strategies, Hess said, he wouldn’t refer to them as watered-down. “The more a strategy relies on illiquidity, the less likely it is to translate well into a mutual fund or exchange-traded product format,” said Hess. “We have found that liquid alternative mutual funds compare best with strategies like long/short equity, which makes up the largest strategy across both liquid alternatives and hedge funds.”

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Since liquid alternatives are still new, the asset management industry hasn’t established a standard definition for these categories of funds. This has caused some investors to miss out on the investment opportunity, and it has investors who have liquid alternatives to use different frameworks when incorporating them into asset allocations, AllianceBerstein said in its whitepaper, “Liquid Alternative: The Next Dimension in Asset Allocation.”

Liquids Lost in Translation? New Strategies Form

Not all hedge fund strategies can be replicated into liquid form, AllianceBerstein said. Liquid alternatives categories haven’t been well-established, and they are evolving so hedge fund categories haven’t translated clearly into mutual fund classifications. 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, so they don’t have long track records; therefore, more time is needed to see them exposed to certain market stressors.

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As these funds evolve, their strategies will become more complex making it a challenge to keep investors informed, Norm Champ, Director of the Division of Investment Management at the U.S. Securities and Exchange Commission (SEC) said in his remarks to the SIFMA Complex Products Forum in October.

However, Hess believes it’s possible that as experienced, alternatives managers’ attraction to  liquid alternatives continue, the level of knowledge and expertise will progressively improve.

]There can be a] disconnect between the strategies and risks that a fund discloses in its prospectus versus the strategies that the fund actually employs

Champ also addressed a few concerns and provided some suggestions about alternative mutual funds. First, he discussed the “disconnect between the strategies and risks that a fund discloses in its prospectus versus the strategies that the fund actually employs.” He suggested revealing “material risks relating to volatility, leverage, liquidity and counterparty creditworthiness that are associated with trading and investments in alternative investments strategies, such as derivatives, that are engaged in, or expected be engaged in, by the fund.” Last, Champs stressed complete and accurate disclosures that are 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 make sure they’re legally compliant with the 1940 Act.

Diversity: Alternatives Grow, Traditional Models Evolve

Meanwhile, some experts have noticed a few trends, such as the increasing amount of management companies launching vehicles and 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. In addition, Charlson noticed a growth in the multi-alternative category, particularly fund-of-fund structures.

As far as the future of these funds, many investors are looking at how the investments will sustain a market correction, said Charlson. “When the time comes and there’s a significant downturn, they will need to do what they say they were supposed to do.”

Alternatives should not simply be seen as an investment that will routinely outperform equity market

“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.” Hess suggests that “alternatives should not simply be seen as an investment that will routinely outperform equity markets.”

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

Most importantly, they 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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