Based on total return performance numbers alone, it seems the proliferation of liquid alternative investment funds during the past five years has been like hosting a Christmas party in January. In other words, a case of bad timing.
Liquid alts, or ’40 Act alternative mutual funds (and to a lesser degree, exchange-traded funds), became the rage after the financial crisis as financial advisors and retail investors saw how well some alternative strategies––particularly managed futures and bear market funds––performed in the face of the global meltdown that hammered most asset classes.
“Alternative investments,” a catchall phrase encompassing a host of different investment strategies, aim to provide a smoother ride over different investment cycles by diversifying portfolios with assets that aren’t correlated to traditional long-only stocks and bonds. In theory, infusing portfolios with different revenue streams can help mitigate drawdowns in bear markets while providing some upside potential across various market conditions.
Formerly the domain of institutional investors and accredited investors via private partnerships, hedge funds and the like, alternatives have entered the mainstream with the rollout of hundreds of funds compliant with the Investment Company Act of 1940 governing open-end funds. But many advisors and retail investors who piled into these products in search of a silver bullet for their portfolios have been disappointed.
That's especially so with investors who evaluate alternatives in terms of total returns versus, say, equities, during a stretch when equities as represented by the S&P 500 have zoomed roughly 190% since the nadir of March 2009. That includes a spectacular 30% rise last year, the index’s biggest annual gain in 16 years.
Meanwhile, the average annual returns among fund categories employing popular alternative strategies such as long/short equity, market neutral and managed futures have ranged from the single digits to negative territory during the past five years. Bear market funds, of course, have been thoroughly trounced during that time.
And despite pockets of volatility in stocks during the massive equity run-up, there haven’t been any significant pullbacks of the sort that allow alternative strategies to strut their downside protection stuff. In fact, the recent economic climate has caused some strategies to flounder.
Take managed futures, which typically uses trend-following strategies employing systematic, rules-based models that seek to take advantage of discernible investment trends––either up or down––in whatever assets they’re following.
That’s worked well in years marked by sustainable market trends, such as 2008. But global markets in the years since the crash have risen and fallen in a choppy, risk-on/risk-off environment marked by a high correlation among asset classes. That means fewer long-running, independent trends that trend-following managed futures strategies can depend on.
Add it up, and you can’t blame investors for thinking liquid alts have been the wrong product at the wrong time. “A lot of investors might be questioning the role of alternatives in their portfolio right now,” says Josh Charlson, Morningstar’s director of alternative funds research. “But they might be losing faith at the wrong time if they think market upside isn’t great at this point.”
Who knows what the future holds, but the long bull market in equities is getting stretched and the looming threat of rising interest rates won’t be kind to bond prices. Given these uncertainties, it’s fair to ask whether liquid alternatives could finally be in the right place at the right time.
“With any of these alternative products, it’s critical to know their role in a portfolio and to buy them for the right reasons because if you have inflated expectations or don’t understand their role you’re likely to mistime your use of them,” Charlson says.
Ditto, says Jason Gerlach, CEO of Sunrise Capital Partners, a San Diego-based alternative investment shop that subadvises the recently launched AdvisorShares Sunrise Multi-Strategy ETF (MULT). “‘Alternatives’ is a broad category, and people need to look behind the label to gauge the experience and competency of the managers, fund expenses and the product’s correlation to things already in their portfolio. I think that last area is one of the most underutilized statistics by RIAs and investors.”
According to Morningstar, the number of distinct liquid alternative mutual funds more than doubled from the end of 2008 through June 2014, resulting in 462 distinct funds across 14 strategies that include leveraged and inverse funds.
Total assets mushroomed from $37 billion at year-end 2008 to $156 billion through the first half of 2014. Long/short equity was by far the largest mutual fund strategy under the alternatives umbrella, with multi-alternative and market neutral comfortably ahead of the rest of the pack at second and third.
There were 303 alternative ETFs with $44 billion in assets as of June 2014, up from 128 funds and $26 billion in assets in 2008. Among ETFs, the three most popular strategies by AUM are trading-leveraged equity, trading-inverse equity and trading-inverse debt, which seems to indicate these funds are used for quick tactical trades rather than for longer-term diversification purposes.
“With more products to choose from, it’s getting harder to figure out who’s essentially a ‘me-too’ provider and who actually has a good track record and strong investment process,” says Ryan Tagal, vice president of product management at Envestnet Asset Management in Chicago, which offers liquid alternative funds on its investment platform aimed at financial advisors.