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 multi-year 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 fortuitous 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.