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.”
Liquid Universe
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.
In a Barclays report this spring on the opportunities for hedge fund managers in the ’40 Act space, the financial services giant said slowing growth in the traditional hedge fund business has made the liquid alternative funds sector an appealing option for hedge fund managers looking to broaden the market for their strategies.
But complying with the ’40 Act requires hedge fund managers to tone down some of their strategies relating to leverage, short selling, liquidity and diversification. And they have to be more transparent.
As a result, some people refer to liquid alternative funds as “alternative lite.” A study last year from Cliffwater LLC found that average annualized returns for liquid alternatives trailed private alternatives by just under 1% during a 10-year period ending March 2013.
Nonetheless, the Barclays report said the growing roster of traditional hedge fund managers entering the ’40 Act space has led to a perception that the overall quality of ’40 Act alternatives “may be improving.”
“My sense is there are more higher-tier players entering the space,” Charlson says. “I think the quality has improved, but I don’t have hard data to support that.”
Fees
One of the big bugaboos about liquid alts are their fees, which, despite coming down in recent years, remain relatively pricey. According to Morningstar, the average expense ratio of the alternative-strategy mutual funds it tracks was 1.78% as of the end of June, while the average expense ratio of alternative ETFs was 0.88%.
One reason for the high fees is that some alternative strategies are inherently more expensive, such as shorting stocks. And multi-alternative funds that provide different strategies from different managers often include fees from both the fund manager and the subadvisors. Another reason for high costs is that some funds don’t have enough scale to reduce their operating costs.
The combination of high fees and poor total returns for liquid alts is a turnoff for some investors.
“Many hedge funds getting into the liquid alternatives are charging high fees because that’s what they expect and they don’t understand the retail market,” Tagal says. “I think you’ll start to see some managers who have a good story and scale and a repeatable process will be reasonable on fees, and that will be good for the alternative mutual fund space.”
Charlson says Morningstar evaluates liquid alternative funds’ performance by looking at their risk-adjusted returns, their performance relative to their peers and their performance against a relative benchmark. “You don’t want to just compare them to straight equity benchmarks because they’re typically hedged-type investment vehicles, so you wouldn’t expect them to fully participate on the upside,” he notes.
Morningstar analysts award gold, silver and bronze medals to funds they expect to outperform over time, and among Charlson’s medal picks for the liquid alts mutual funds he follows are gold for the TFS Market Neutral Fund (TFSMX) and silver for the AQR Diversified Arbitrage I fund (ADAIX) in the market neutral space, and a silver for the AQR Managed Futures Strategy I fund (AQMIX) in the managed futures segment.
Expectations
Given that liquid alternative funds are designed to smooth volatility and deliver decent returns in the process, have they fulfilled their mission during the past five years? An easy question, but it’s not so easy to answer.
Jim Holtzman, a financial planner with Legend Financial Advisors Inc. in Pittsburgh, says his firm has switched its clients’ alternative investment exposure from private limited partnerships to open-end mutual funds for liquidity and transparency reasons. “From a risk mitigation standpoint, we believe they’re serving their purpose,” he notes. “But regarding returns, we would’ve expected more in this environment. It’s been a real challenge.”
Dan Moisand, a financial planner and principal at Moisand Fitzgerald Tamayo LLC in Melbourne, Fla., sees the growth in liquid alternative funds as another example of investors chasing a hot trend.
“Liquid products are created because they can be sold,” he says. “That’s classic Wall Street. Whatever is hot they’ll create products to put people into. The point I make all the time is there’s not one client who risks failing to reach their goals because they don’t own any alternatives.”
Nonetheless, advisors haven’t given up on liquid alternative funds. Nadia Papagiannis, director of alternative investment strategy for global third-party distribution at Goldman Sachs Asset Management, says she’s seen a change in emphasis in how advisors approach alternatives.
“Most advisors we’ve talked to are less concerned about an equity market drawdown than they are about rising interest rates,” she notes, adding that alternative investments have historically done well in rising interest rate environments.
Papagiannis says she has measured six rising rate environments since 1990 (the inception date of the HFRI Fund of Funds Composite Index, which can be used as a proxy for alternative funds), and in those environments alternatives had positive returns all six times and the returns were substantially better than the Barclays U.S. Aggregate bond index.
“If you’re heavy into bond exposure and you want to diversify, alternatives are a potentially good way to do that,” Papagiannis says.
Ryan Tagal at Envestnet says he’s seeing growing interest in liquid alternative funds from advisors on his company’s investment platform, particularly in non-traditional fixed-income funds with mandates to be more tactical in credit and duration.
Tagal says Envestnet’s platform contains roughly 600 liquid alternative funds (including various share classes). “Envestnet has a broad platform, and we want to give advisors access to a lot of products,” he says. But of those 600 funds, only about 140 are approved (meaning the Envestnet research team has looked at them and compared them with their peers), and of these, only 15 are considered to be top picks.
“These have been vetted regarding fees, hedging strategies and proper risk controls,” he says. Among those top picks are the BlackRock Emerging Markets Long/Short Equity fund (BLSIX), the Robeco Boston Partners Long/Short Research fund (BPIRX) and the AQR Managed Futures Strategy I fund (AQMIX).
Tagal says Envestnet recommends an allocation of up to 25% in alternative mutual funds in some of its models. He adds that Envestnet educates interested advisors about how to deploy alternatives in client portfolios.
“We’re spending a lot of time digging into it because there are more products out there, and we want to be able to provide context to advisors to help them make the choice of whether they ultimately want to use them and how they fit into a portfolio,” Tagal says.