Investors aren’t as thirsty for liquid alternative mutual funds and ETFs as they were in the years immediately following the financial crisis. According to Morningstar, total net assets in these funds, which rose from around $74 billion in 2010 to more than $178 billion in 2014 amid a proliferation of new products, have stabilized and even shrunk a bit.

“Generally, demand for alternatives is not great in the case of prolonged bull markets like this,” says Tayfun Icten, an analyst in the multi-asset and alternatives group at Morningstar. With equities pretty much trending straight up for eight years, he says, people are less inclined to seek the three things they expect from alternatives: unique return drivers, uncorrelated returns and some downward protection.

Their performance hasn’t helped their popularity either. While it’s unreasonable to expect alternative strategies, on aggregate, to outperform equities in this market, he says, “At the end of the day, I would expect, as an alternatives analyst, to see better risk-adjusted returns, better bang for the buck, when you invest in alternatives.”

One problem is that managers who can’t find enough alpha-driven opportunities for their ballooning assets are parking more money in cash, where returns are nearly nonexistent. Low interest rates have also compressed risk premiums, which is challenging such strategies as merger arbitrage and convertible arbitrage, he says.

But investors should be paying more attention to liquid alts, particularly if they anticipate a rapid rise in interest rates, unexpectedly high inflation or increased volatility in the equity and bond markets. Such risk factors “would probably produce a better opportunity set, more fertile ground for alternative funds,” says Icten.

Jeff Davis, chief investment officer of Boston-based LMCG Investments LLC, agrees. “In the rearview mirror, liquid alts do not look good at all,” he says, because anything diversified away from credit risk, duration risk and equities has performed very poorly. However, “It’s probably just about the time to be thinking very seriously about a larger commitment to liquid alts,” he says.

The big issue, he says, is that the standard allocation of 65% stocks/35% bonds may not be sustainable much longer. Stocks (especially U.S. stocks) and bonds (including Treasurys) are arguably close to peak valuations, historically, he says.

By December 2016, U.S. stocks were already pricing in the beneficial effects of long-lasting tax reform on company earnings and capital formation, he says. But, he adds, it’s still hard to say whether the reforms promised by President Trump and the Republican Congress will actually happen, he says.
For now, “Trump leads to high valuation, high valuation is risk, [and] risk leads to the need for diversification, which leads to liquid alts,” he says.

People who’ve been richly rewarded by investing in index funds also need to realize the S&P 500 is “dominated in a very concentrated way,” he says, by the technology giants. Its top 10 components by index weight include Apple, Microsoft, Alphabet, Amazon and Facebook. “You have a point where winners are taking all and that’s usually an unsustainable period of time,” he says.

He notes that during the tech bubble collapse of 2000 and 2001, active managers employed a variety of strategies (market neutral, global macro and directional long-short) that performed much better than the indexes.

Additional Appeal
Michelle Borré, the sole portfolio manager of the Oppenheimer Fundamental Alternatives Fund and the lead portfolio manager of the Oppenheimer Capital Income Fund, also sees valuation risk as a key reason to consider liquid alternatives. Stock market valuations are pretty high, there’s been little earnings growth over the last couple of years, and the cyclically adjusted price-earnings ratio is high, she says.

“From these levels, the next 10 years of equity returns have generally been pretty low, if you look back over 100 years,” she says.

Using liquid alts on the fixed-income side also makes sense to Borré. The yield to maturity for bonds is too low to mathematically expect fixed income to rally strongly as it has over the past 35 years, she says. She also thinks it’s important to reduce duration exposure—the sensitivity of bonds to interest rates.

Rates will rise if the economy gets a boost from deregulation, tax cuts, repatriated capital and increased infrastructure spending, she says. She also notes the people being floated to fill vacancies and expiring terms at the Fed are much more hawkish than dovish (favoring tighter monetary policy rather than historically low rates).

Global risk is another reason to consider liquid alts, she says. If China’s above-trend credit growth is followed by a slowdown in credit growth—which has typically occurred elsewhere—it could impact global GDP, global markets and other economies, she says. As for Europe, where Brexit and key elections signal rising fragmentation, “Our longer term view is it’s an unstable equilibrium,” she says.

Overall, “We think the traditional assets over the next five or 10 years won’t do as well,” says Borré, “and alternatives will be more valued in a portfolio because of the diversification they provide.”

Nicolas “Nico” Amato, head of alternative portfolio management for Wilshire Funds Management, which closely tracks liquid alts, also sees a strengthening case for these hedge-like funds.

For the first time in a long time, the markets are starting to see much more dispersion, he says. Not only has the correlation within sectors fallen, he explains, but it’s also very low between sectors. This makes it easier for active managers to show how they can add value. Already, “We’re starting to see more alpha through security selection,” he says. He also expects market volatility to rise as risk-free rates rise.

What’s Hot And What’s Not?
Manager selection is extremely important in liquid alts. An “average” return doesn’t reveal much about what’s happening in a category, says Icten of Morningstar, because its funds can have vastly different objectives and performance.

Still, he thinks long-short equity and market neutral are probably better positioned going forward than other strategies because they look more at stock-specific niche opportunities. “These opportunities are generally there regardless of market environment,” he says.

Conservative investors seeking bond-like risk return profiles may want to consider merger arbitrage strategies, he says. Managed futures, which look for big trends to emerge, remain very challenged by range-bound markets, he adds. For example, the U.S. dollar, crude oil and 10-year rates can’t find their direction and keep reversing.

Icten likes the Boston Partners Global Long/Short Fund (BGLSX). Its track record isn’t great because international stocks haven’t done particularly well in the past three to five years, he says, but diversification into international markets may be likelier now that many investors think U.S. stocks are overvalued. Boston Partners has a solid investment process and team, he adds.

Another fund he likes is the JPMorgan Hedged Equity Fund (JHEQX), which he says reduces equity risk by investing in equities with an option collar strategy. The fund looks like a 60/40 portfolio, he says, but there’s no duration risk because it doesn’t invest in bonds.

Borré encourages advisors to think about “the roles and the goals” of liquid alts. In other words, she asks, what role is a fund expected to play and is that goal realistic given the characteristics of that fund?

Her multi-strategy Oppenheimer Fundamental Alternatives Fund (QVOPX) invests in long-short equity, long-short credit and long-short macro. The macro portion includes currencies, commodities and sovereign debt. “We call it long U.S. dollar, short everything else,” she says. “We think there’s less tail risk here.”

She is concerned that slowing growth in China could lead the country to further devalue its currency—and the impact of that, she says, could ripple to China’s trading partners Thailand and Japan. She thinks Europe and Japan have too much leverage, which she says could be a long-term drag.

Davis of LMCG Investments views market neutral as a great starting point for investors looking for little or no relation to the stock or bond markets. “The category is not the most exciting from a total return perspective,” he says, but it can outperform stocks and bonds during market disruptions.

Three years ago, LMCG Investments converted its global market neutral strategy from a limited partnership into a mutual fund. The fund (GMNRX) is designed to provide Treasury yield plus 3% to 4% on a fairly consistent basis, he says. LMCG is looking to bring more liquid alt teams to the firm.

Amato is pleased to see some flattening out in the liquid alts space. “There was definitely too much growth, too much product,” he says. “There needs to be, I won’t say consolidation, but rationalization.” In other words, does a fund make sense and is its return worth it?

The strategies he’s a little more excited about are global macro and equity hedging. They tend to translate better from the hedge fund world to the mutual fund world, he says. The translation is harder for event-driven strategies, he adds.

Stronger Vetting
Thomas Meyer, CEO of Meyer Capital Group, a fee-only RIA firm based in Evesham, N.J., anticipates a market correction and is using alternatives as diversifiers and “shock absorbers,” he says. “My biggest worry is an absolute herd of elephants is going to run through that little door.”

But his firm, which wraps liquid alternatives around cheap ETFs, has pared down its liquid alt universe and slightly reduced its allocation to these strategies. Liquid alts now account for roughly 10% of its more than $800 million of assets under management. “There’s a lot of junk out there and advisors have to be wary of this,” says Meyer. “You have to do your due diligence.”

“The highway is littered with the carcasses of great alternatives managers who went from the non-liquid platform to the liquid platform and they failed,” he adds, noting that maintaining daily liquidity is a huge challenge. One fund that saw its flows skyrocket and then plunge, he says, was the Marketfield Fund (MFLDX). Meyer Capital Management once had a very large position in it.

Among the funds Meyer Capital Management currently uses for diversification are the Vanguard Market Neutral Fund (VMNFX), the Boston Partners Long/Short Equity Fund (BPLEX), the Boston Partners Long/Short Research Fund (BPRRX), the Guggenheim Macro Opportunities Fund (GIOAX) and the Pimco Income Fund (PONDX).

Educating clients about beta and how liquid alts can offer downside protection helps temper their resistance to the higher fees, says Meyer. “It’s not just about the indexes or the alternatives,” he tells them. “We’re molding the two together.”