Liquid Alternatives Feel More Fluid to New Investors

Investors Seek Greater Flexibility with Alternative Funds

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 alternative funds, 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 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 out of billions of dollars, and the regulatory scrutiny of hedge funds ignited fears and raised concerns.

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 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 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.

Liquid alternatives have undergone a growth spurt. Between 2013 and 2018, the liquid alternative market increased to a total worth of $225 billion in the U.S., and Canada’s market could soon surpass $20 billion. Surveys also show that 20% of institutional investors and 10% of current investors are considering moving assets into liquid alternative ETFs in 2020. With the liquid alternative market booming so quickly, what do the experts have to say?

Liquid Alternatives: 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, but 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.

Financial journal Real Assets Adviser cites a Cliffwater study on “liquid alt” performance, which found that liquid alternative investments generally have lower returns than traditional hedge funds, even when following a similar strategy. Due to global regulations and the effect they have on liquid alternative funds, these funds may seem like a consolation prize for retail investors who cannot otherwise invest in private hedge fund products.

Illiquidity Strategy Doesn’t Flow, Some Argue

Not all experts agree with the above sentiments. 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.”

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 caused investors who have liquid alternatives to use different frameworks when incorporating them into asset allocations, according to the AllianceBernstein  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. 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, so they don’t have long track records. Therefore, more time is needed to see them exposed to certain market stressors.

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) explained in his remarks to the SIFMA Complex Products Forum in 2015. Even in 2019, experts like Shana Sissel, a senior portfolio manager at CLS Investments, have stated that underperforming strategies can be hard to explain to investors.

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

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 investment strategies, such as derivatives, that are engaged in, or expected [to] be engaged in by the fund.”

Lastly, 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: 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. In addition, Charlson noticed a growth in the multialternative category, particularly fund-of-fund structures.

As far as the future of these alternative 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.”

“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.”

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 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.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Basic Investment Principles 101 – From Asset Allocations to Zero Coupon Bonds 2019 and What is a “Private Fund?”. This is an updated version of an article originally published on January 7, 2015.]

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