It’s gut check time for many portfolio advisors. Investors have logged robust gains in stocks and bonds in recent years, but the temptation to lock in profits has rarely been greater. Not only have the major market indexes failed to move higher in the past 18 months, but stomach-churning events like the recent “Brexit” kerfuffle point to a market with little reward and ample risk.

While “moving to cash” offers the play-it-safe route for many, liquid alternative funds offer a clear alternative. The best of them can deliver positive absolute returns in most market conditions and possess little correlation to stocks and bonds.

Stretched To The Limit

At the midpoint of 2016, some think traditional equity valuations look overstretched. Analysts at Credit Suisse note that S&P 500 valuations stand at 1.49 standard deviations from the historical norm. “In the past, when this model has crossed the 1.5 standard deviation mark, the S&P 500 has fallen on a 12-month forward basis 58% of the time,” they wrote in a recent note to clients.

Toss in a rising set of headwinds, including weak corporate profit growth, a noisy political season and economic strains in China and Japan (the world’s second- and third-largest economies), and stocks may be in for a bumpy ride. “A market without support of strong earnings growth or cheap valuations is going to experience heightened volatility,” predicts Scott Clemons, chief investment strategist for private wealth management at Brown Brothers Harriman.

Meanwhile, the bond market hardly looks like a source of portfolio upside. The safe haven status of fixed income has pushed global yields down to historically low levels, and it’s hard to see how bond prices can rise much higher. According to Jefferies & Co., $10.4 trillion of bonds now offer yields below zero. That’s a scenario that could not have been predicted by any economist just a few years ago. 

Against that backdrop, many investors have embraced liquid alt funds, which employ hedge-fund-style strategies to provide diversification and positive absolute returns in choppy markets. 

Still, this asset class has endured a challenging multiyear stretch in the face of ever-rising stock and bond markets. And even within specific liquid alt sub-categories, the return dispersion can be wide. 

Looking at Goldman Sachs Asset Management’s liquid alternative investment multi-strategy peer group, the top-performing fund was up 6.5% year-to-date through June 24, while the worst was down 10.2 %, notes Nadia Papagiannis, the director of alternative investment strategy for GSAM’s Global Third Party Distribution.

These funds, which she didn’t name, allocate differently to underlying strategies, and if market conditions change, this year’s leader in a particular category could be next year’s laggard. “We have seen that different alternative investment sub-strategies do well each year,” Papagiannis says. 

Rather than look at the short-term performance of a multi-strategy fund, she suggests that investors look at factors such as the longer-term track record and the experience of the management team behind the fund. Even among three-year records in many of these sub-categories, you’ll see a wide level of dispersion in returns. That’s why manager selection is crucial. The best liquid alt fund managers have been able to build a winning track record over time, and are able to back up their performance with a clear and compelling investment strategy. 

We took a close look at the top-performing liquid alt funds, and are highlighting the best of breed in several categories. 

The managed futures category remains popular with investors, despite tepid performance from many fund offerings. Matt Osborne, chief investment officer at Altegris, notes that assets in this group have swollen from $3 billion in 2009 to a recent $28 billion. That’s a 49% compound growth rate.

He thinks current events such as the recent Brexit vote set the stage for continued appeal for managed futures funds. And Osborne notes that we’re starting to hear more about the rising prospects of an economic recession, “which is likely to put more pressure on richly valued equities.” That would presumably boost the appeal of the diversification benefits of managed futures funds and other liquid alt strategies. 

The Cherry Pickers

Indeed, the strategists at Altegris Advisors are sitting in the catbird seat. They have been conducting an extensive amount of research on hedge fund managers since 2002. By 2010, they entered the liquid alt space, selecting the cream of their research to help select managers to sub-advise their various liquid alt funds. 

The approach has clearly paid off. The Altegris Managed Futures Strategy fund (MFTIX), for example, is up 9.1 % over the past year, and a handful of similar managed futures funds offered by Altegris have delivered similar robust returns in that time. 

“While many managed futures funds focus squarely on trend-following, we take a broader approach in this fund,” says Osborne. The strategy includes hedge fund firms Quantitative Investment Management (QIM), which focuses on pattern-based time series prediction methods in its futures contracts selection, and Lynx Asset Management, which is a more traditional trend follower, and funds such as these are key reasons the MFTIX fund has performed well. Notably, those two sub-advisors’ approaches are not highly correlated with each other.

Does Not Correlate

Let’s pause for a moment and consider the primary purpose of hedge funds, and the liquid alt funds that aim to emulate them. Sure, they want to make investors money, but they are really built to provide asset exposure away from the traditional stocks-and-bonds axis.

That’s the clear mission of LoCorr Funds. It even has “low correlation” in its name. “Because it’s our core focus, we’ve been able to partner with some of the best hedge fund managers,” says Ruxandra Risko, senior vice president, national accounts at LoCorr.

The firm offers six different liquid alt funds, which have accumulated more than $2 billion in assets in the five years since the fund family was launched. That’s no mean feat in a very crowded marketplace.

It helps to have a solid track record. The LoCorr Managed Futures Strategy fund (LFMAX), for example, is up more than 9% in 2016, and also up more than 9% annually over the past three years. That’s slightly better than the S&P 500 in that time, and with a lot less volatility.

The fund deploys the skills of three different strategies, all of which take approaches that have a low correlation to one another. Sub-advisor firm Millburn Ridgefield uses price forecasting in its managed futures program, and takes up approximately half of the portfolio. Another subadvisor, Graham Capital, uses a mid- to long-term trend-following approach, and Revolution Capital Management’s “Alpha” strategy uses a shorter-term focus approach.

To be sure, many of these sub-advisor strategies might appear dauntingly complex to retail investors. “That’s why we help advisors learn about these solutions and how to implement these strategies in client portfolios,” says Risko. Indeed, a number of liquid alt funds are enhancing their advisor communication and education efforts to help demystify a sometimes murky asset class. 

The Meta-Analysis Managers

To deliver category-beating returns, fund managers often need to take a very distinct approach. The fund advisors at AlphaSimplex LLC look to profit from investor behavior in the various asset classes the firm manages. The firm’s core principles were developed by Dr. Andrew Lo, an MIT professor who built what the firm calls an “adaptive markets hypothesis.” 

“We’re looking for behavioral biases that can justify momentum and trends in markets as investors adapt to new information,” says Duncan Wilkinson, the firm’s CEO. For the firm’s ASG Managed Futures Strategy fund (AMFAX), 70 different futures contracts (spanning stocks, bonds, commodities and currencies) are studied for key trends, which can be driven by “fundamental factors or simply by fear or greed,” Wilkinson notes. 

“We want to know how the market is reacting, and we want to measure the risk” embedded in futures contracts. “We don’t try to predict a trend; we just try to follow it,” he adds.

That form of market meta-analysis has paid off nicely. The fund has racked up a 6.44% annualized return since 2010, compared with 0.44% in the managed futures category, Morningstar says. It’s also notable that the fund has a near zero correlation with the S&P 500. In all, AlphaSimplex manages five liquid alt funds with a combined $7 billion in assets for France’s Natixis Global Asset Management. 

The Long/Short Formula

Since the S&P 500 has been flat for the past 12 months, this should be an ideal time for long/short funds to shine. But that hasn’t been the case for most. The average long/short fund is off 7.5% in the past year. Only AQR Capital Management, Otter Creek Advisors, Boston Partners and LJM Partners have managed to deliver gains of at least 7.5% in their long/short funds in the past year.

Here’s an area where a sound set of investment principles are needed to underpin long-term fund performance. “We’ve been focusing on long/short funds since 1998, long before liquid alts were even a category,” says Jay Feeney, co-CEO and chief investment officer of Boston Partners. His firm runs long/short funds focused on the U.S., developed markets and emerging markets. The Boston Partners Long/Short Equity Institutional fund (BPLSX) fund has returned 8% over the past year, and garners five stars and a Bronze rating from Morningstar. 

Most managers will suggest that success in this category is as simple as finding overvalued and undervalued stocks. “That’s a losing approach,” says Feeney, noting that stocks with high valuations can maintain their momentum for an extended period.

He thinks a much deeper set of investing factors must be used. Boston Partners focuses on three key traits for its long positions: the company must have an attractive valuation; it must have quality cash flow paired with favorable capital deployment; and it must have underlying business momentum such as upward sales revisions. 

On the short side, Boston Partners seeks out what it calls “failure characteristics,” which Feeney highlights as high valuations, poor cash generation (paired with weak balance sheets) and deteriorating business momentum. Broadly speaking, the long positions are typically large caps while the short positions are primarily small and mid-cap companies. 

Feeney and his research team also avoid the trap that many managers fall into when they build a very large position in a long or short “high-conviction” pick. “We do not believe in concentrated positions. It’s too easy to have a blowup that way,” he adds. The fund has more than 400 positions, and no position accounts for more than 2.5% of the fund. 

Liquid Alts In An ETF Wrapper?

Underwhelming investment returns have been a key challenge for the liquid alt industry. To be fair, many of the liquid alt funds are merely mirroring the equally tepid returns of their hedge fund counterparts. That can be chalked up to a market environment that seems to have solely favored stock and bond bulls in recent years. Liquid alts are at least a better bargain than the many “two and 20” hedge fund fee structures.

That doesn’t mean the liquid alt funds are clear bargains either. That’s why some firms are beginning to think about liquid alt strategies with much lower fees, the kind found in exchange-traded funds.

At the end of 2014, in a bid to sidestep the crowded liquid alt field, New York Life Insurance Co. acquired Index IQ, which had built a series of liquid-alt style funds. That firm’s IQ Hedge Multi-Strategy Tracker ETF (QAI), for example, has garnered four stars from Morningstar and has more than $1 billion in assets. 

Adam Patti, the CEO of Index IQ, seems thrilled at the chance to link up with a large firm like New York Life. “Until a year ago, we had no distribution and little marketing budget,” he says, adding that the distribution support now in place is helping many of Index IQ’s other liquid alts-style funds increase their assets at a more rapid pace.

It’s notable that in April 2016, Hedgeweek named Index IQ’s Multi-Strategy ETF the “Best ’40 Act Liquid Alternatives Fund.” It was a wake-up call for the industry, which has largely skirted the issue of somewhat high fees and largely ignored the world of ETFs. 

New York Life’s decision to buy into an ETF platform to become a bigger player in liquid alts may portend additional moves by major players that feel the need to respond to the fee-related concerns. One thing is for sure. This is an industry that is still evolving in search of the right approach with advisors and investors. The industry growth thus far has been impressive, but the next half-decade may require bolder product offering strategies and enhanced investor education.