The tsunami of liquid alternative investment funds introduced in the aftermath of the financial crisis continues to surge along with investor interest, and neither is expected to retreat in the foreseeable future.
According to Morningstar, the number of distinct alternative mutual funds more than doubled from year-end 2008 to September 2014. The universe now includes 463 funds across 14 strategies. Total assets over this period ballooned from $38 billion to $161 billion. The figures don’t include nontraditional bond funds, which can use alternative strategies.
In addition, there were 325 alternative exchange-traded funds with $45 billion in assets as of September 2014, up from 143 funds and $26 billion in assets at year-end 2008. Alternative mutual funds, regulated by the Investment Company Act of 1940, use strategies designed to help buffer portfolios from market risk and provide a smoother ride.
Although liquid alts have amassed a huge fan club, many skeptics question the big appeal. Recent annual returns for many alternative fund categories have been pedestrian while the stock market has soared, and long-term performance is often hard to find. Alternative mutual funds sport an average expense ratio of 1.9%, compared with 1.21% for actively managed mutual funds in traditional asset classes, according to Morningstar. It can also be difficult to understand or confirm complex strategies a fund purportedly uses.
So what’s keeping the liquid alts market hopping? Josh Charlson, Morningstar’s director of manager research for alternative strategies, says it’s a convergence of several factors.
Investors and advisors want additional tools that can provide diversification and downside protection from traditional stocks and bonds. Accredited investors are growing increasingly disenchanted with hedge funds’ high fees (historically, 2% of assets and 20% of gains) and liquidity constraints. Further, more hedge fund managers are exploring opportunities in the registered-fund space as raising capital for hedge funds gets tougher.
Charlson and others feel that allocating to liquid alternatives is important given the risk of stock market volatility and the likelihood of rising interest rates, which would hurt bond returns. Even so, “Advisors really have to understand the role they play in a portfolio and not just chase them because they’re the new hot thing,” he says.
He suggests asking fund managers about their track records, fund objectives and experience selecting subadvisors if they use them. Morningstar provides ratings on more than 50 alternative mutual funds, which many advisors source.
Those starting to dip their toes into alternatives may be most comfortable with long-short equity strategies, which can work well as a piece of an equity allocation, he says. The pullback this year in net inflows to long-short equity, the distant leader by assets among Morningstar’s 14 categories, doesn’t concern him. “They were sort of crazily high and have come down from the stratosphere,” he says.
Advisors seeking greater diversification can use a multi-strategy fund of funds but should be prepared to pay the extra layer of fees that’s baked in, he says.