Investing in the alternative investment asset class has historically been challenging. Over the years, a variety of investment solutions have claimed to open access to strategies previously available only to institutions and the most well-heeled families. But more often than not, the solutions—be it hedge fund of funds, liquid alternative funds or interval funds—have been poor facsimiles of the real McCoy.
Private wealth advisors have long desired to make alternative asset classes like private equity and debt, real estate, infrastructure and commodities available to their clients to enhance portfolio strategy. Alternative investments can be an important part of a well-diversified portfolio, and there are more offerings and structures than ever before.
Access has always been a challenge and some products and strategies have generally been so laden with fees and structural flaws that it has made them unpopular or ineffective.
The search for a better mousetrap has continued, as advisor demand has grown. Investing with the right fund managers is key as the stark difference in returns from top quartile funds versus the remaining universe of alternative managers is well documented. But access to premier institutional managers has traditionally been a privilege reserved for only the wealthiest.
That may be changing. More direct, cost-efficient entry points to these managers are opening. A growing number of advisors are finding one of the easiest and most efficient ways to access these managers is to partner with third-party independent platforms that can provide access to top-tier institutional managers’ flagship funds in a high-touch, client-centric manner.
Liquid Alts: Lost In Translation
These platforms avoid many of the impediments that have long blocked broader access to alternatives. Throughout the mid- to late-2000s, funds of funds became a common way for advisors to gain exposure to top managers. Unfortunately, fee pressures and poor performance from hedge funds coming out of the Great Financial Crisis hurt these hedge funds of funds, and today the industry is a fraction of what it used to be. In addition, technological improvements allowed more hedge fund strategies to be implemented in the liquid alternative space within a mutual fund structure. However, liquidity and short disclosure requirements and restrictions on private holdings have limited the effectiveness of buying these offerings compared to private partnerships.
One of the biggest complaints about alternative investment partnerships is the fee structure. Unlike a mutual fund where the sponsor typically earns a management fee, performance-based carry or incentive fees are very common for alternative investment strategies, which increase the overall cost to investors. Alternative strategies typically are more expensive, so accessing top-tier managers is paramount to justifying these costs. Moreover, fees will detract from the alpha generation that enables these managers to outperform their peers. For example, large wire houses often add expensive platform fees and access costs on top of the alternative fund manager’s fees. These factors can dramatically impact the internal rate of return and multiple of invested capital that an advisor’s client receives, especially compared to institutional investors.
Due to some of these cost nuances, we’ve seen an evolution within the alternative investment industry. Many of the premier alternative investment brands are searching for ways to reach high-net-worth (“HNW”) clients, so numerous independent investment platforms have entered the market. Accordingly, more fund sponsors are coming out with tender offer or interval fund structures to allow retail investors direct access to their strategies. While these structures can provide entry points to some of the better-known and well-respected managers in the industry, advisors need to be cognizant of the multiple limitations of these types of funds.
Liquidity: Feature Or Flaw?
While interval funds allow greater access to alternative managers, there are opportunity costs to utilizing them. One of the biggest drivers of performance for many alternative strategies is the illiquidity premium they generate. The illiquidity premium can protect investors from pulling capital out of the markets at the wrong times, especially during times of stress and overzealous selling. Having the ability to withstand more market noise has been key for many hedge fund managers with more permanent capital where they can allocate into market stress while other fund managers are forced to sell to meet redemptions. An attractive aspect of these tender offer or interval funds is that they often allow for more liquidity than typical alternative structures, all while maintaining similar investment mandates. The additional liquidity can come at a cost compared to a private partnership. Since interval funds are required to keep cash on hand for weeks around their quarterly payout dates, they will be less invested compared to a similar partnership offering. That available liquidity will likely lead the interval fund performance to lag. As such, there is less of an illiquidity premium available for these types of funds if they are forced to sell into a stressed market during these liquidity windows. Registration and compliance filing requirements also create additional costs to these types of funds compared to partnership offerings.