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.
 

Rick Lake, co-founder and co-chair of Lake Partners, a Stamford, Conn.-based consulting firm with 25 years’ experience in alternative investments and a 15-year track record in liquid alts, says he is pleased to see the widening availability of alternative strategies in liquid formats and an accelerating migration of highly experienced alternative managers from the institutional and private world.

“We may be entering a golden age of liquid alternatives,” says Lake, whose firm had approximately $4.7 billion of consulting assets and $656 million of assets under management as of September 30. “But distinguishing experienced managers from newcomers is key,” he says.

To sort through the plethora of options, advisors and investors will need to devote more time and resources to liquid alts research or align themselves with firms that have a dedicated liquid alt research team, he says. “Advisors will need to climb the learning curve or find the research support,” he adds.

This past summer, Lake’s Aston/Lake Partners LASSO Alternatives Fund (ALSOX/ALSNX) reduced its allocation to long-short equity because of concerns about potential volatility, and redeployed some assets to long-short fixed income and global macro strategies. Global macro aims to capitalize on changing dynamics in equity, fixed-income, currency and commodities markets.

The LASSO (Long and Short Strategic Opportunities) fund of funds now allocates about half its assets to long-short equity (U.S. and global), 30% to long-short fixed income, 10% to arbitrage and event-driven strategies and 10% to global macro.

Lake says he likes to see a “robust translation” when an alternative strategy is carried over from a private hedge fund to a liquid regulated structure. “Sometimes the original strategy is diluted so it’s an issue of concern,” he says.

Translation is also very important to John Shearman, CEO of IV Lions LLC, a San Francisco Bay Area RIA firm, and previously a partner at a global alternative investment advisory firm. “If a strategy is pulled from the hedge fund world and pushed through the ’40 Act, what comes out on the other side?” he says.

Factors that can be lost, he says, include leverage, the illiquidity premium and manager talent. Another key consideration with liquid alts, he says, is risk shuffle—swapping out standard deviation risk in exchange for an increase in risk of a large, unexpected loss.

He does like that liquid alts can help advisors expose clients to diversifying sources of return without the risks that can accompany hedge fund investing, such as illiquidity, complex tax structures and leverage-related financing woes.

Shearman, who recently co-authored the book Liquid Alts: A Guide For Financial Advisors and Advanced Investors, was surprised to see so many liquid alts being used in the retail market. “There’s really a revolution going on,” he says. Portfolios he inherits often have long-short credit and arbitrage strategies in place.

Staying Well-Hydrated
Meyer Capital Group, a fee-only investment management and financial planning firm in Marlton, N.J., began using liquid alts around 2007 and currently allocates nearly 20% of its approximately $750 million of assets under management to them. All of its roughly 650 clients have exposure to them. “It’s a great way to bring these types of strategies to the mass affluent,” says CEO Thomas Meyer, referring to people with $500,000 to $1 million in investable assets.

Still, “It’s not a silver bullet,” he tells clients. “It’s a shock absorber for your portfolio.” He teaches them the fundamentals of liquid alts but avoids being too technical.

Meyer says the flood of new products is getting out of hand. “Every Tom, Dick and Harry firm is basically trying to get into liquid alternatives right now, which makes our jobs as RIAs more difficult,” he says. Not only does it require more due diligence, he says, “Probably 70% of this stuff hasn’t even been battle-tested.”

Meyer asks managers how they manage risk and about consistency of risk-adjusted returns. He also asks them why the strategy should add value over time, in what market environment the product would have difficulty outperforming and what enhancements they have made to their investment process in the last five years.

The funds he uses that employ alternative strategies include Schooner I (SCNIX), Gotham Absolute Return (GARIX), two Robeco Boston Partners long-short products (BPRRX and BPLEX), Iron Strategic Income (IFUNX), JP Morgan Strategic Income Opportunities (JSOSX) and John Hancock Strategic Income Opportunities (JIPIX).

The income funds provide exposure to high-yield bonds and derivatives. “We’d never do this stuff on our own,” says Meyer. “We haven’t bought a bond in two years.”
 

Aaron Izenstark, co-founder and chief investment officer of Iron Financial LLC, a Northbrook, Ill.-based firm that focuses on liquid alts and manages about $2.5 billion in assets, encourages advisors to look under the hood to see what managers are trying to achieve.
Unconstrained bond or nontraditional bond really doesn’t tell you much, he says.

For its part, the Iron Strategic Income Fund hedges interest rate risk with futures and hedges credit risk with credit default swaps. It also goes long and short on ETFs and yield curve opportunities when it sees relative value.

Izenstark says it’s important to check how a strategy managed through a rough period and even how a strategy reacted to overnight catastrophic news. For example, if one claims it can protect against rising interest rates, see how it performed during the second quarter of 2013. “During these crazy market times is when you really need an alternative,” he says.

More than ever, “Advisors are waking up to try to find things that make a statistical difference to their portfolios,” he says. Those he works with generally allocate 10% to 30% to liquid alts. Typically, below 10% doesn’t make much of a difference, he adds.

Brian Haskin, founder, CEO and chief investment officer of Alternative Strategy Partners LLC, a Los Angeles-based investment-consulting firm, says his clients—advisors, family offices and high-net-worth and institutional investors—seek to reduce portfolio volatility. Many are also tapped out on traditional fixed-income products and looking for new ways to capture some additional yield, especially if interest rates rise, he says.

He expects opportunities in long-short equity, managed futures and event-driven strategies. The past five years have been rough for most managed futures, but he thinks lessening intervention by the Federal Reserve and dislocation among central banks’ policies will help them serve as diversifiers in portfolios. Event-driven strategies should do well as merger and acquisition activity continues to pick up, he says.

Reality Check
Larry Restieri, head of alternative sales for global third-party distribution at Goldman Sachs Asset Management (GSAM), which has been building out its liquid alt offerings and focusing on related education, encourages advisors to set realistic expectations.

If clients are concerned their alternatives aren’t keeping pace with the rise in equities, he says, explain that’s not what they’re designed to do and show them how they can help smooth out a portfolio.

Advisors and investors can access information and an alternative investment allocation tool in the liquid alternatives center on GSAM’s public website. According to data cited by Goldman Sachs, retail investors allocate less than 5% to alternative investments, compared with nearly 25% for institutional investors. Individual client allocations should be based on their liquidity needs, long-term goals and time to retirement, says Restieri.

As of September 30, GSAM had $113 billion in alternative investments, including $4.1 billion in seven liquid alternative funds. Its offerings include its Absolute Return Tracker Fund (GARTX/GJRTX), Multi-Manager Alternatives Fund (GMAMX/GSMMX) and single-strategy funds. Advisors building their own portfolios should make sure they are diversified, he says.

Restieri expects continued broad adoption of liquid alts and an expanded range of implementation options. “We’re big believers in this category of funds,” he says. “We think they’re here to stay.”

Asset managers are also introducing managed-account platforms that help investors access customized alternatives. “The ease of investing through a platform—while it’s not a mutual fund where it’s literally point, click, invest—provides many of the same attributes,” including liquidity and transparency, says David Young, president of Chicago-based Gemini Alternative Funds LLC.

Gemini focuses on managed futures in its platform, which is currently available only to accredited investors. It vets the 28 commodities advisors it uses and looks at their activity daily. When reviewing fees for any platform, Young says it’s important to verify what operating costs may be included, such as administration, auditing and reporting.

The high fees associated with liquid alts are often a deterrent. Bob Gerstemeier, founder and president of Gerstemeier Financial Group LLC (a fee-only RIA firm in Chicago and Cincinnati) and chair of the National Association of Personal Financial Advisors (Napfa), typically avoids them because of fees and because it’s tricky to select active managers.

“You are essentially playing roulette when picking the fund you use,” he says. “We have no idea who the best manager is going to be in the future.” Instead, he uses more traditional types of investments categorized as alternatives, including REITs and commodities. Some of his clients have private equity exposure in limited partnerships.

Meanwhile, some industry experts remain hopeful that nontransparent active ETFs will get the green light from the Securities and Exchange Commission despite its recent ruling against an application filed by Precidian Investments and BlackRock.

Haskin, of Alternative Strategy Partners, says it’s a clear setback for these firms and others pursuing a similar “blind trust” structure. “However, I don’t think the ruling is a game stopper,” he says. He thinks it clarifies the SEC’s views about specific aspects of nontransparent ETFs, which will help providers refine their proposed offerings.

He still expects nontransparent ETFs to hit the market in 2015, although he says this could be delayed. “Obviously, more work is still required before the SEC is fully comfortable with a structure that will protect individual investors,” he says.

Meyer, of Meyer Capital Group, expects an eventual onslaught of managed and unmanaged ETFs to bring fee compression, but thinks they will be transparent. “We’re going to see a sea change,” he says, “which will ultimately be very good for the individual investor.”