Whenever the investing seas get rough, investors seek shelter. And in 2008, that spelled opportunity for liquid alternative investments, which tend to be non-correlated with stocks and bonds. Yet as the waters have grown calmer in recent years, “liquid alts” have drifted from the spotlight.
An Unfair Fight
Liquid alt funds have delivered a mixed bag of results in recent years, ranging from modest gains to outright losses. Meanwhile, the S&P 500 delivered an 80% return in the four years ended 2014. For many, what appeared to be a safe investment instead became an albatross in clients’ portfolios.
Yet as 2015 unfolds, liquid alts are getting a fresh look. And credit goes to a newly volatile global economic environment.
A surging dollar, slumping oil, the potential for rising domestic interest rates and an expanding U.S. trade deficit are all signposts of a shifting market foundation. Simply put, the benign economic backdrop of the past half-decade is no longer in place. “The markets are behaving strangely, there is a sense that risk is heightened,” says Lucas Turton, chief investment officer at Windham Capital Management.
And that’s where liquid alts come in. That umbrella term, which encompasses a range of investing strategies including managed futures, global macro, long/short credit, event-driven investing, arbitrage and other strategies, provides various ways for investors to preserve capital gains while still being positioned for further upside. Liquid alt funds are registered with the SEC under the Investment Company Act of 1940.
Although the liquid alt label has become a catchall for any investment approach outside the traditional bond/stock axis, these approaches share one common trait: They are all “market neutral,” meaning they are ostensibly built to flourish in both bull and bear markets.
A decade ago, the liquid alt fund category encompassed around $30 billion in assets under management, though that figure now exceeds $300 billion, according to Morningstar. Much of the growth has come from traditional hedge funds as liquid alts have become a viable alternative for institutional investors and financial advisors—if not retail investors.
A key distinction: These funds offer transparency and liquidity (i.e., the ability to instantly sell) whereas hedge fund investors may sometimes feel they are locked into a black box. Liquid alt fund managers are also prevented from taking “swing for the fences” portfolio positions, while hedge fund managers can blow a hole through a portfolio with one bad trade.
Despite the still-rising appeal of liquid alt funds, it’s fair to question why they fared so poorly in the first few years of this decade. Steve Mason, a portfolio manager at Collins Capital, believes the investing backdrop was simply too challenging. “It was hard to find price differentiation, and volatility was also very low,” he says.
Mason thinks October 2014 signaled an important time for liquid alt investors. That’s when the Federal Reserve ended its multiyear bond-buying program, known as quantitative easing. Collins says the end of QE had an initial impact on currency markets, but is now playing out in other areas such as futures contracts.
Andrew Rogers, CEO of the Gemini Companies, which helps fund firms create and launch new products, also sees a much more fertile environment for liquid alt funds—especially in the category of managed futures. “There are a lot of events in play for managed futures fund managers to work with,” Rogers says, adding that assets under management have been growing steadily in this sphere in the past few quarters. According to Morningstar, managed futures funds, on average, have risen an impressive 18% over the past year.
The managed futures funds are the largest sub-category in the liquid alt spectrum. These funds are run by commodity trading advisors (CTAs), who typically deploy long and short positions in a range of futures contracts covering commodities, currencies, stock indexes and bonds. These CTAs really earn their keep when rising uncertainty boosts volatility. Higher volatility equals wider futures contract spreads.
Yet industry watchers caution that it’s unwise to look at these investments as a way to beat the market. Instead, look at them as vehicles to reduce portfolio risk. “We think of managed futures as a classic diversifier, a sort of insurance policy” says Ryan Tagal, an associate portfolio manager at Envestnet, which provides portfolio advisory and management services.
In 2012, Envestnet polled financial advisors to see how they view liquid alt investments. The ability to “reduce portfolio volatility/provide more diversification” was the most popular response. In contrast, fewer advisors believed that such investments should be used as a “defensive play/bear market protection.”
Indeed, further stock market gains and liquid alt exposure are fully compatible goals, according to Nadia Papagiannis, the director of alternative investment strategy at Goldman Sachs Asset Management. “We are still expecting double-digit stock returns, but alts can give you positive returns with one-third of the risk [of stocks].” She adds that liquid alt categories not only have a very low correlation with stocks, but also a very low correlation with one other.
That explains why many advisors are increasingly seeking out liquid alt funds that have exposure to a variety of sub-categories. For example, the Collins Alternative Solutions Fund (CLLIX) works with various hedge funds to provide broad liquid alt exposure. The Collins fund currently has 20% of its assets deployed in an “event-driven” fund, but it also invests in global macro (14%), arbitrage (13%), long/short credit (12%), activism (9%) and four other categories.
It’s interesting to note the dual focus on event-driven and activist investing. “Companies have a lot of cash and are under pressure to pursue buybacks, dividends and acquisitions,” says Collins Capital’s Mason. “And activists are working all the angles.”
Still, the fund-of-funds approach that Collins Capital and others utilize doesn’t come cheap. The CLLIX fund, for example, has a 2.49% expense ratio. Many other liquid alt funds carry expense ratios of more than 2%.
Cliff Stanton, the chief investment officer at 361 Capital, thinks investors should put expenses in context: “High fees on their own are a concern, but if the strategy is effective, then those fees are justifiable.” He’s also concerned that some liquid alt funds have hidden fees that aren’t initially spelled out in the marketing literature. “Advisors need to focus on that as part of their due diligence.”
Stanton is able to speak critically about expense concerns because his firm’s funds have delivered solid returns. For example, the 361 Managed Futures Strategy Fund (AMFQX) has delivered 5.9% annualized gains since its launch in December 2011, even as many of its peer funds have merely posted breakeven results since then.
Morningstar’s Jason Kephart thinks 361 Capital has the right approach. “The Institutional share class’s 1.89% price tag is by no means cheap, but compared with peers that use CTAs as subadvisors and layer on extra management and performance fees, it’s a relative bargain,” he wrote in a fund update. He assigns the fund a four-star rating.
361’s Stanton attributes the relatively strong performance to a “counter-trend” approach that deploys funds whenever managed futures contracts have heightened spreads. While some fund managers may try to predict the direction of key economic trends, “we don’t spend much time focusing on fundamental topics (such as oil, the dollar and interest rates). We simply thrive on volatile markets, which has been the case since last October,” he adds.
The AQR Managed Futures Strategy Fund (AQMIX) takes the exact opposite approach, directly following key trends in currencies, commodities, equities and fixed income. The fund is positioned “with the assumption that ongoing recent trends will continue,” says Yao Hua Ooi, a principal at AQR and a portfolio manager for the firm’s AQMIX fund.
Volatile markets have been a clear positive, helping this fund deliver a 19% return over the past 12 months. While the investing backdrop that emerged in the final months of 2014 has remained in place thus far in 2015, how do fund managers know when a particular trend (such as the rising dollar) has unfurled too quickly and is poised for a reversal? “We have some measures to help identify when trends are overstretched,” says Yao, “and we proactively cut back on the level of risk we are taking.”
AQR Capital Management, which was named Alternatives Fund Manager of the Year by Morningstar in 2013, has been steadily expanding into a broader range of liquid alt funds such as those in global macro and long/short equity. The firm, which deploys a small army of quantitative analysts, is seen as one of the thought leaders in the alternative funds space, with more than $120 billion in AUM. The company’s historical track record should help those newer funds gain traction in the marketplace.
Indeed the track record of various funds (and their managers) is a topic you’ll hear about quite often in the area of liquid alts, partly because of the broad range of returns. In the managed futures category, for example, the Equinox Chesapeake Strategy I fund (EQCHX) has generated a category-leading 52% return (through March 20, 2015), according to Morningstar. A considerable number of other managed futures funds have delivered negative or flat returns in that time. “That highlights the importance of finding the right fund manager,” says Envestnet’s Tagal.
Josh Charney, Morningstar’s alternative investments analyst, also stresses the importance of the firm behind the fund. When deciding which funds get a gold, silver or bronze rating, “we look for solid management teams that have a transparent and reasonable process. On the parent side, we’re looking for well-capitalized firms that bring alpha generation and low expenses.”
Charney is a fan of AQR, and also cites the investing acumen of Boston Partners, which was designated Morningstar’s Alternatives Fund Manager of the Year in 2014 for its Long/Short Equity fund (BPLSX). Charney thinks the fund’s managers “have robust alpha generation and are very savvy short sellers.” That’s no mean feat in a bull market where short sellers have largely taken a beating.
While managed futures are the biggest category in the liquid alt space, the current economic backdrop should be favorable for many other approaches. The key question, says 361 Capital’s Stanton, is this: “What [global economic] risks are most concerning to you, and what strategies do you pursue to mitigate that risk?”
Given the duration of the current bull market, Stanton acknowledges that investors may no longer want a fully bullish orientation. “Investors want to participate [in stocks], but they want more protection,” he says.
One form of protection comes in the form of long/short equity funds, which were cited in a July 2014 survey by Barron’s and Morningstar as the most appealing liquid alt category among both institutional investors and financial advisors.
As you’d suspect, these funds have had a hard time keeping pace with the major stock indices during the six-year-old bull market. Yet if stocks start to move sideways, the outlook for such funds could brighten.
Even against a backdrop of recent stock gains, a number of long/short funds are starting to gain traction. AQR, for example, has posted 20% returns over the past 12 months in its long-short fund (QLEIX).
The Bond Plan
While the outlook for stocks may remain more positive than negative for most investors, the same can’t be said for bonds. Indeed, the Fed’s growing hints that rate hikes are coming have led investors to seek out capital preservation strategies. For example, the long/short credit funds should generate solid returns once interest rates start to rise and spreads between long-term and short-term interest rates start to expand.
Ryan Roderick, a managing director at Goldman Sachs Asset Management, notes that the HFRI Fund Weighted Composite Index, which serves as a useful proxy for liquid alt investments, has risen in value during the past six periods of rising interest rates.
Going Global
Funds that adhere to a “global macro” strategy have also moved into favor recently, especially as economic uncertainty remains elevated in China, Europe and elsewhere. This strategy gives fund managers wide latitude to pursue a range of long or short positions in various asset classes, based on their reading of economic trends and government policies.
Global macro funds won’t deliver eye-popping returns. Instead, they seek to outperform cash and bonds while assuming only a moderate amount of risk. The John Hancock Global Absolute Return Strategies Fund (JHAIX), for example, is the largest global macro fund with $6 billion in assets and has generated an 8% return over the past 12 months, according to Morningstar.
Now that liquid alt investments are moving back into the spotlight, investors need to understand that the various fund offerings don’t just offer the chance to bag a quick profit. “I think you should own this approach for the long haul, and not just be a trend-chaser,” says Morningstar’s Charney. “The strategy has shown to provide great portfolio diversification, but my concern is that investors have shown no sense of timing on these and have tended to bail on them at the worst times.”
Envestnet’s Tagal also thinks the liquid alts category should be seen as an all-weather investment. He notes that many financial advisors are moving away from “style-box investing” toward “goals-based planning.” He concedes that “liquid alts won’t outperform stock over the haul, but it will greatly reduce volatility.”
Considering the heightened volatility we’re now seeing in the currency and commodity markets, and may soon see in the stock and bond markets, liquid alts may soon find a growing role in many portfolios.
A Liquid Alt Renaissance?
May 2015
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