It’s time for some soul-searching in the financial services industry. Over the past five years, dozens of firms have collectively launched hundreds of alternative investment funds, known as “liquid alts,” yet many potential clients continue to steer clear of this emerging asset class. Blame for the disconnect goes to a case of lousy timing and a key misconception. Yet the year ahead promises a brighter outlook for liquid alts, and fund marketers are redoubling their efforts to highlight the asset’s appeal.

Make no mistake, the torrid post-recession rally in stocks and bonds created a lousy backdrop for liquid alts. They are built for hedge fund-style strategies, emphasizing capital preservation as much as capital gains. While investors reaped an impressive 14% annualized gain with stocks in the five years ended 2014 (and garnered solid gains in bond funds as well), most alternative funds have delivered modest gains, and some have delivered outright losses. 

Yet as investors again learned in 2015, stock and bond prices don’t always head north. And when bull markets come to an end, alternative investments can really shine. Indeed, such assets provided important stability to portfolios in periods of turmoil, like we saw in 1998 and 2000 and again in 2008.

Outsized gains in those years have enabled alternative investments to largely keep pace with stocks. According to Hedge Fund Research Inc. (HFRI), stocks have risen an average 0.79% per month in the 20 years ended 2014. Alternative investments have posted a 0.70% monthly gain in that time. Considering how massively stocks outperformed alts in the final five years of that analysis, it becomes apparent that alternative investments fared quite well in the prior 15 years. 

More to the point, alternatives have delivered respectable long-term gains with much lower volatility. Over the 83 down months in the 20-year period, stocks fell an average of 3.87%. Alts fell by just 1.07%, according to HFRI. Said another way, the stock market’s wild swings over the past 20 years have produced a standard deviation of 15.5% according to Invesco, while alternatives have had a standard deviation of 5.7%. 

In the past, bond funds typically provided a source of lower volatility for portfolios. But after a remarkable rally that dates back to 1982, bond yields may be headed up and bond prices may be headed down in coming years. “Bonds may not act as the ballast they historically have,” predicts Jeff Sarti, co-president of Morton Capital Management.

A Looming Shakeout?
To be sure, the liquid alternatives segment is ripe for an overhaul. Thanks to an aggressive slate of new product offerings over the past few years, there are now 642 liquid alt funds, according to Goldman Sachs Asset Management. Many of those funds lack enough assets under management to remain viable for their fund sponsors, and the coming year may represent a tidal shift in terms of fund closures. “There’s no way to sustain the number of funds that are out there. Many of them won’t survive,” says Jeff Davis, chief investment officer at Boston-based LMCG Investments and manager of the LMCG Global MultiCap Investor fund (GMCRX). 

Ahead of any sort of potential industry shakeout, investors should focus on the strongest offerings in the various liquid alt categories. “This is a really good time to start comparing alt funds, as many of them have now produced three-year returns,” says LMCG’s Davis. 

Still, many investors aren’t equipped to make a thorough assessment and are still moving up the learning curve with these assets. “People are struggling to grasp the key issues such as correlation (with stocks and bonds), performance in various markets and the role of alts,” Davis adds.

Helping investors to understand the merits of liquid alts remains an unmet challenge for many fund sponsors. Some fund firms, such as AQR, Invesco and American Century Investments, are building out more product research on their websites, though more work needs to be done. “The real innovation needs to come from the academic side, which would be helpful for people to better understand these funds,” says Davis. 

Cleo Chang, head of alternative investments at American Century, a $150 billion global asset management firm, agrees that greater industry communication about the merits of these vehicles will be required. “There continues to be growth in assets under management in the category,” she says, “but we need to further the education of advisors about how best to use them.” 

It doesn’t help that the Federal Reserve and other central banks have continued highly accommodative monetary policies, which has distorted traditional risk and reward relationships. “There’s evidence of complacency that has led investors to downplay risks,” says Chang, “which has made it harder for liquid alts to flourish in recent years.” 

To appreciate the merits of liquid alternatives, investors will need to shift away from a traditional focus on annualized absolute returns. Indeed, it is a challenge to track the performance of liquid alts in general, simply because the various alt strategies flourish in different kinds of markets. 

Thus far in 2015, for example, managed futures funds have risen roughly 6%, according to Morningstar, handily outperforming stocks and bonds. Most other categories (such as multi-alternative, market neutral and long/short equity) have posted only modest gains, while “bear market” funds are heading for a double-digit loss this year. Indeed, that category has generated a 21% annualized loss over the past five years, and when you consider that stocks rise in value most years, this category may not have much of a future. 

Broadly speaking, “this year’s performance has been in line with what you’d expect,” says Josh Charlson, director of alternative funds research at Morningstar. Charlson, like many alt strategists, insists that performance shouldn’t be measured by returns relative to stocks, but instead on a risk-adjusted-return basis. Many alt funds are constructed to maintain a fairly low beta, a key measure of volatility. 

While various alt categories tend to offer varying levels of return and volatility, they can be blended together to deliver a portfolio that delivers ideal risk-adjusted returns. That’s the logic behind multi-asset or “multi-strategy” funds, which deploy a basket approach. 

Morton Capital’s Sarti believes that multi-asset funds can be helpful tools for broad-based portfolios. “They bring a lot of diversification to retail investors, but we caution that you really need to understand what you are getting. Many liquid alt funds are simply a mix of stocks and bond positions and carry more traditional market risk than many investors realize,” he says.

Lowell Yura, the portfolio manager of the BMO Alternative Strategies Fund (BMATX), deploys his fund’s assets among a half-dozen specialty sub-advisors. (Some multi-asset funds work with up to 20 sub-advisors, which can greatly dilute the impact of sub-advisor selection). Balancing assets among hedged equity, relative value, hedged credit and global macro enables Yura to retain a portfolio beta in the 0.30 to 0.35 range. 

Yura is quick to note that the fund is not constructed to deliver great bull market results. “The typical investor already has ample stock and bond exposure, so we’re optimizing the right liquid alt approach that can augment the typical 60/40 [stock/bond] construct,” he says, adding that the fund’s sub-advisors don’t rely on economic cycles to deliver their returns. Eliminating market and economic cycle risk is a key consideration these days in light of the fact that we haven’t seen a bear market or a recession in the past six years. 

While many investors focus on the quality of management in their alt funds, some simply seek out the lowest cost options. After all, in many portfolios, alts play a satellite role rather than a core role, and the typical 2% expense ratio of liquid alts can eat away at returns.

Index IQ, which was acquired by New York Life’s Mainstay Investments division in April 2015, offers a low-cost approach, with exchange-traded funds (ETFs) that are built to deliver hedge-fund-like returns with expense ratios below 1%. (That expense ratio looks especially enticing when you consider the “1 and 20” cost burden of many traditional hedge funds.) 

The IQ Hedge Multi-Strategy Tracker ETF (QAI), for example, shifts assets among six alt categories: global macro, long-short equity, emerging markets, event-driven strategies, market neutral strategies and fixed-income arbitrage. “As hedge funds change their allocation, we reallocate our weightings,” says Adam Patti, CEO and founder of Index IQ. “There’s very little alpha,” he concedes, “but it provides a multi-asset beta.” His firm also offers five other ETFs that replicate hedge fund strategies, although the QAI fund is the firm’s top dog, with roughly $1 billion in assets. 

Morningstar’s Charlson is also cognizant of investor concerns about high expense ratios for many alt funds, especially those that aren’t delivering solid risk-adjusted returns. “With this niche, there can be a lot of layering of sub-advisor management fees,” he says. To justify expenses that are higher than those of a typical stock or bond fund, Charlson says it’s crucial to look for fund firms that have a “great deal of experience in terms of selecting underlying managers.” 

In that context, Morningstar assigns a positive rating to the Litman Gregory Masters Alternative Strategies fund (MASNX), which has built a strong reputation for manager selection and portfolio diversification. The fund has delivered the best Sharpe ratio (another measure of risk-adjusted returns) in the multi-asset category, according to Morningstar.

The liquid alternatives niche is still evolving, and though the weaker hands are likely to shake out, further innovation is also likely to take place. “There are so many new ideas out there, and new ways to manage money that go beyond the 60/40 [stock/bond] approach,” says LMCG’s Davis. “I am extremely optimistic that current research is going to yield great new approaches.” 

The fund industry’s challenge is to capture the interest of more retail investors—through better education and, presumably, solid risk-adjusted returns in a potentially tumultuous stock and bond market in 2016.