You can almost feel the palpable sense of relief among the fund managers that operate in the liquid alternatives (“liquid alts”) category. Choppy stock and bond markets that first appeared in the summer of 2015 have finally created a more favorable backdrop for these funds.

Liquid alts follow hedge fund-style capital preservation strategies while still seeking absolute positive returns. And recent performance bears out a modest renaissance. As a broad proxy, the HFRI Fund Weighted Composite Index has risen for three straight months (through February 29). If such market conditions persist throughout 2016, then these funds may finally post the strong risk-adjusted returns that many of their backers have been waiting for. 

Make no mistake, it’s been a difficult multiyear stretch for these funds, as unprecedented actions taken by the Federal Reserve produced a spectacular secular bull market for traditional stocks and bonds, preventing traditional alternative asset strategies from performing as expected. 

But the backdrop is improving. “Now that the Fed isn’t playing as central a role in markets, some liquid alts strategies are again showing the kinds of benefits that have historically led to impressive risk-adjusted and non-correlated returns,” says Matt Osborne, chief investment officer of Altegris Advisors. 

For investors that like the general approach of hedge fund strategies, but wince at the “2-and-20” fee structure, liquid alts are clearly a better deal. According to Wei Ge, a senior researcher at Eaton Vance’s Parametric Portfolio division, traditional hedge fund management fees will consume 85% of all investor returns over a 50-year time frame. The average liquid alt fund fee, in contrast, would eat up just 21% of returns.

Returns All Over The Map

Still, investors are cognizant of the troubled recent past for liquid alts. “On average, many of these funds didn’t deliver the kinds of returns that many had been expecting,” says Jack Hansen, chief investment officer for Parametric’s Minneapolis Investment Center. Even in the relatively healthy market backdrop of the last six to eight months, many liquid alt funds continue to deliver negative returns, albeit less negative than the equity market. 

That performance issue, coupled with a surplus of products in an increasingly crowded field, is leading to a modest industry shakeout. While an average of 91 new liquid alt funds were opened each year from 2011 through 2015, fund closures have become the more recent theme. In 2015, 149 of these funds were shuttered, and we’re seeing elevated rates of fund closures again in 2016, according to Morningstar. 

It may not be wise to lump all of the liquid alt funds together. Returns among the various sub-categories have greatly varied, and some of them may not be suitable for the liquid alt approach.

Take the unconstrained bond fund category as an example. Hedge funds are able to expertly navigate these assets, even though they can often be illiquid and require lots of leverage to generate returns. In that context, “these kinds of alt funds just don’t translate very well,” says Osborne. 

Yet other strategies appear better suited to the liquid alt wrapper. Managed futures funds, for example, have built solid long-term track records going back to 2000, according to research conducted by Altegris. Such funds are once again racking up respectable recent returns, now that volatility has returned to the market, says Osborne. He adds that trend-following, especially in fixed income and energy, has been a very fruitful strategy in 2016. 

Rebuilding The Image

In the face of tepid multiyear returns for many liquid alt funds, the heavy inflow into the funds has slowed to a trickle. According to Morningstar, industry fund inflows peaked at $97 billion in 2013 and slipped to $37 billion in 2014. In 2015, roughly $6 billion in assets flowed out of these funds, a trend that continued in the early months of 2016. 

To be fair, traditional stock and bond funds saw much greater outflows in 2015. Yet that exodus from the traditional “60/40” (stock-bond) approach is not tangibly boosting the flows for liquid alts, as was the case in 2008 and 2009. 

Larry Restieri, head of alternative sales for global third-party distribution at Goldman Sachs Asset Management, thinks that liquid alts are faring better than some may realize. “While the performance was underwhelming on an absolute basis in 2015, they did what they are supposed to do,” he says. 

Restieri notes that these funds are built to correlate with their hedge fund counterparts, and relative to equities, they are clearly reducing portfolio volatility. A study conducted by Goldman found that liquid alternatives outperformed their traditional, non-traded counterparts in 2015.

A Maturing Phase

Despite the recent spate of fund closures, few think that the niche has already peaked. “What’s taking place is the natural sorting out of a segment of the mutual fund industry that experienced rapid growth and has become to a certain degree oversaturated,” noted Morningstar’s Josh Charlson in a recent report. 

Yet for investor interest in these products to keep building, it’s increasingly clear that the industry “needs to raise the bar concerning the knowledge of these products,” says William Kelly, CEO of the Chartered Alternative Investment Analyst Association (CAIA).

In 2014, the association launched a 21-hour online course that provides a comprehensive alternative investment education curriculum. As advisors become better educated on the various aspects of alt investing, they also become better positioned to explain such strategies to their clients. “These investments have tangible portfolio benefits that may not be readily understood by the average client,” Kelly says. 

“Advisors have a tough job [with alt investments],” he adds. “It’s not just picking the right strategy, but also picking the right manager.”

It’s that last point that pops up repeatedly in industry discussions. For firms like Envestnet PMC, the process of manager selection is crucial. The firm, which provides portfolio advisory services, focuses on an “Alpha Thesis” when it comes to liquid alt funds. 

“First, we want managers to clearly articulate the market inefficiency they are trying to exploit,” says Ken Shaw, Envestnet’s senior vice president. All liquid alt fund managers will tell you that their proprietary approach is superior to the peer group, but fund results don’t always back up that sentiment.

As a second test for these funds, Envestnet PMC looks at the size of the research team behind any liquid alt fund managers. Obviously, that approach is bound to favor the bigger firms that have access to the top fund managers and researchers. 

In fact, with the entry of big firms such as Blackstone, Goldman Sachs, BlackRock and others making a big push into liquid alts, smaller firms with limited distribution reach are starting to feel the heat. That factor helps explain the recent rising tide of fund closures, according to Shaw. 

Restieri notes that some firms may have underestimated the hedge-fund-to-mutual-fund transition. “You don’t necessarily need a big infrastructure to run a hedge fund, but mutual funds require a lot of layers of administration.” For liquid alt funds that haven’t amassed sufficient assets to manage, an eventual closure may be inevitable. 

Meanwhile, firms that have had previous success in hedge fund management, such as Millburn Corp. or Informed Portfolio Management (IPM), are increasingly partnering with traditional retail fund management firms to launch liquid alt mutual funds. “The big hedge funds have learned that it’s hard to make the transition to mutual funds on their own,” says Andrew Rogers, CEO of Gemini Funds Services, a full-service fund administrator providing compliance, distribution and risk reporting services. 

High Fees? Low Fees? Yes

The other industry challenge involves fee structures, which tend to be much lower than those of hedge funds but higher than those of traditional mutual funds. And in light of the market share that stock and bond ETFs have taken from their mutual fund counterparts, it’s fair to ask if a similar trend will play out among liquid alts. 

Indeed, a number of the bigger firms such as Goldman Sachs and Blackstone are moving to cover both bases. “Certain alt approaches will lend themselves to passive management, while others will still require an active hand,” says Restieri. Goldman has been rolling out new liquid alt mutual funds and ETFs simultaneously. 

Altegris’s Osborne concurs, noting that “there is a continuing move towards lower fee solutions.” He is seeing an emergence of quantitative strategies that focus on factors such as carry trades or value-versus-growth algorithms. Those funds can utilize smaller portfolio management teams and can pass on the savings as a result. 

Baby Boomers To The Rescue

Perhaps the single greatest factor in favor of liquid alts is demographics. Roughly 10,000 baby boomers turn 65 every day, and that trend will stay intact for the next 14 years.

These investors are a natural fit for liquid alts’ capital preservation approach. For any investors that hoped to retire near the end of the last decade, the sharp market drops in 2008 and 2009 led to a painful readjustment in the timing of retirement. Soon-to-be retirees today are surely cognizant of that period.

In a recent white paper entitled “Liquid Alternatives: The Next Wave in Asset Allocation,” the alternative asset management team at Lazard Asset Management noted that liquid alternative strategies offer “a potential buffer to equity market downturns.” They think baby boomers will need “assets with characteristics such as lower volatility return streams, some measure of capital preservation during negative market environments, and diversification.” The key takeaway: “Liquid alternative funds will be a solution that is increasingly part of the asset allocation decisions for millions of Americans.”

Cream Rising To The Top

With so many new funds hitting the market in recent years, performance is starting to become the primary selling point, especially in lagging sub-categories. In the long/short category, the average fund has lost an average of 5.7% (through March 22, 2016). Yet some managers, like Harin de Silva, president of Analytic Investors, have started to build a strong following.

De Silva’s firm sub-advises the 361 Global Long/Short Equity Fund (AGAQX), which has delivered a 7.8% return over the past year. The approach is quite transparent. For every $100 invested on the long side in low-beta and low-volatility stocks, another $30 is used to short high-beta stocks. 

De Silva thinks that long-only strategies can only benefit from a rising market. “But in a long/short strategy, you need a much defter hand,” he says. The recent market backdrop has been favorable for him and his team. “The choppier the market, the better for us.”

But the dispersion of returns among long-short funds has been all over the place. Successful short sellers “combine macro insight, thematic analysis, and fundamental stock selection with specialized risk-management techniques,” says Rick Lake, co-chairman of Lake Partners.

Profitable shorts in recent market downdrafts capitalized on evolving market dynamics, according to Lake. “Last summer, investors grew increasingly discriminating in stock selection. This created multiple short opportunities—weak companies that were no longer being lifted by a rising market, former ‘hype’ and ‘hope’ stocks that were unable to meet unrealistic expectations, and companies that were leveraged to a downturn in energy and commodities.”

Investors can also choose from a variety of other funds that have generally delivered category-beating returns and high marks from Morningstar. The AQR Managed Futures Strategy Fund (AQMIX), which gets a five-star rating from Morningstar, has scored in the top 10% of all managed futures funds on a three- and five-year basis. The 1.23% expense ratio is also below the industry average. The fund takes a complex but thus far successful approach to price movements in various asset classes. Its managers invest in futures contracts covering four asset classes (stocks, bonds, commodities and currencies) and alters various weightings in response to short-term and long-term technical trends.

John Hancock’s institutional arm has posted impressive results working with a number of sub-advisors. In 2014, the Boston Partners Long/Short Equity fund was named Morningstar manager of the year in the alternatives category, and in 2015, the John Hancock Global Absolute Return Strategies fund and Boston Partners Long/Short research fund were both runners up.

The BlackRock Multi-Asset Income Portfolio Investor C Shares (BCICX) fund has been a top performer in the multi-asset category. The fund, which invests in stocks, bonds and a range of alternative investments, has a dual focus on capital preservation and income generation. The fund, which merits a “Bronze” rating from Morningstar, benefits from the broad set of research resources that BlackRock Investments can offer to the fund management team. 

Perhaps the greatest measures of performance and value for liquid alt funds can be found in their Sharpe ratios (for risk-adjusted returns) and fund expenses. By those measures, the Vanguard Market Neutral Fund Institutional Shares (VMNIX) fares quite well. The fund’s 0.95 Sharpe ratio is tops in its category, according to Morningstar, while the 0.15% expense ratio (it’s 0.25% for retail investors) is almost unheard of in the liquid alt space. 

A Transitional Year

In many respects, 2016 is shaping up to be a transitional year for the liquid alts industry. The frenzied pace of asset inflows after the Great Recession of 2008 and 2009 has come to an end, replaced by a rotation away from some approaches that have lost popularity (such as non-traditional bond funds) and toward approaches that are seen as more relevant for today’s markets (such as managed futures funds).

The industry is also welcoming the increased attention of traditional asset management firms such as Blackstone and Goldman Sachs, along with retail investing giant Vanguard. And thanks to enhanced educational efforts industrywide, investors are slowly moving up the learning curve with these funds. Despite some recent industry growing pains, the asset category, and the funds that back them, should garner greater acceptance in the years ahead.