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.