Revelers in Pamplona, Spain and liquid alternative mutual funds and ETFs (known as “liquid alts”) share a key trait. Neither can withstand the stampede of a raging bull. For much of this past decade, a steadily rising bull market led a wide range of liquid alt funds to lag the gains posted by stocks. These hedge fund-like products aim to profit from volatility and uncertainty.
Fast-forward to 2022. Suddenly, these funds are posting respectable returns, making up for lost ground in a hurry. Meanwhile, outside of public markets, a whole new set of alternative investing options have emerged for advisors looking to capture the alpha generated by private markets. Let’s take a closer look at each segment of this diversified asset class.
Godot Finally Arrives
Many advisors likely overlooked liquid alts because for years they produced mediocre returns. These funds are built for volatility, after all—or to create positive returns when stock and bond prices are slumping, which they weren’t doing. It’s a shame, because now people likely realize that liquid alts exposure would have helped stabilize portfolios that have gone underwater in recent quarters.
To be sure, some advisors (and retail investors) did make the proper pivot. After five straight years of net outflows, liquid alt funds took in $31.83 billion in 2021, according to Morningstar. And the interest continues to grow. “Every single category [of liquid alts] has seen positive inflows this year,” says Simon Scott, Morningstar’s head of alternatives research.
He notes that “hedged equity” funds captured the largest amount of new monies. These funds own equities and also buy options contracts to serve as a hedge to offset losses connected to market risk. Through the end of May, the category saw a further $6.9 billion in net inflows. With $24.7 billion in assets under management (through mid-June), the JP Morgan Hedged Equity Fund (JHEQX) is the category’s biggest and garners a five-star and “Silver” analyst rating from Morningstar.
Trend-following funds, which follow a strategy using the technical analysis of changing market prices, have also seen solid net inflows of $4.3 billion this year, “which is no surprise when you see how well they have done,” says Scott. The average fund in the group is up 22% through May of this year, with some funds such as the AQR Managed Futures Strategy Fund (AQMIX) and the AlphaSimplex Managed Futures Strategy Fund (AMFAX) both up more than 45% through the end of May. Scott adds that “trend following in bonds and commodities has been strong, particularly for those that have higher volatility targets and so can run higher leverage.”
Will volatility in markets continue for the rest of the year? With the Federal Reserve aggressively raising interest rates, high inflation creating economic strains and a growing possibility of a recession later this year, the answer would seem to be yes.
Lacking a crystal ball on the direction of equity markets for the remainder of 2022, advisors may want to explore another pair of liquid alt categories: market neutral funds and long/short funds, which are aimed at providing stable returns (or at least more muted negative returns) when stocks are slumping.
The Private Pivot
Advisors are also increasingly embracing alternative assets that trade in private markets, such as private equity, venture capital, private credit (also known as “direct lending”) and hard assets such as infrastructure.
In a February article published by Morningstar, titled “When History Rhymes,” Scott wrote that “while pension funds and longer-term liability matchers have long incorporated these assets into their portfolios, more recently a broader range of institutional investors, and even high-net-worth individual investors, have been making the crossover.”
Tapping into private markets makes sense when you consider that many companies choose to remain private rather than endure the scrutiny and regulatory burden of public entities. According to Morgan Stanley, companies have raised more money in private markets than in public markets every year for more than a decade.
But investing (or lending) in private markets has a clear drawback that liquid alts don’t: restricted liquidity. You can redeem private market money only a handful of times per year at best—and sometimes not for five or seven years. So these investments should represent just one sleeve of a client’s asset base, the part earmarked for longer-term wealth generation.
Besides liquidity problems, advisors also face the twin challenges of due diligence and regulatory hurdles when they want to put clients in private investments or loans. And that’s where a new breed of fintech firms have emerged. Atlanta-based Gridline is a recent entrant in the growing field, aiming to “provide access to top quality professionally managed funds,” says CEO Logan Henderson. “We also wanted to streamline the back-office process, creating an experience similar to what online brokers offer,” he adds. Gridline’s platform provides a “self-directed process for advisors,” adds Henderson, enabling them to test-drive the options themselves, though a salesperson is also available for a teach-in if needed.
Many top-performing alternative funds were previously inaccessible for advisors and their clients because of the high minimum buy-in requirements. Gridline’s “fund of funds” offerings start as low as $100,000. That’s perhaps too high a hurdle for many clients, especially as such investments should never account for more than 5% or 10% of a portfolio. But it’s more feasible for wealthy clients and others who qualify as accredited investors.
Investors in this space who focus on best-of-breed managers with long track records will get better returns than they would in public markets, Henderson notes. “The top quartile has delivered an [internal rate of return] in excess of 30%,” he says.
Thais Gaspar, a global alternatives strategist at Brainvest, notes that her firm offers alternatives access in areas such as private credit, mezzanine loans and venture capital. The firm invests on behalf of its clients and is not an “alts fintech platform” like firms such as Gridline or CAIS.
The firm’s value add is instead in finding the most appealing investments from a risk/return perspective. “We’ve been especially focused on private credit and are increasing our exposure to it. Such investments are higher up in the capital stack, which gives us better protection against defaults,” she says.
Gaspar adds that her firm’s private credit investments tend to focus on opportunities with shorter duration, often 12 to 36 months. “This can be an even shorter time frame than equity holding periods,” she notes. Still, any such private investments will always lack the liquidity of their public counterparts. Gaspar says investors are still getting suitably compensated with excess returns for the illiquidity discount.
Notably, shorter-term private loans are often tied to variable benchmark interest rates, a key consideration when such rates are on the rise. However, Gaspar adds that there can be a six-month time lag before higher rates filter into private credit loans.
On the equity side, Gaspar says that VC funds currently hold greater appeal than private equity funds. “PE funds may be more likely to suffer from downward revisions in valuations,” she says. Also, venture capital fund managers have a clearer exit path than PE funds in today’s environment, the strategist notes. Still, as an alts investor will tell you, “manager selection is crucial,” stresses Gaspar, adding that “vintage diversification” is another consideration, since investors don’t want to be overly concentrated in a specific period of maturities.
Gaspar has noticed a change in the makeup of today’s alternatives investor cohort. “The alternatives investor base used to be more institutional, but now we are seeing more family offices like Brainvest and high-net-worth investors express interest in the search for better risks/rewards in their investments,” she concludes.
It’s growing harder to neatly sum up the alternatives landscape. The publicly traded liquid alt funds are purpose-built for volatile markets and smoother returns, while the private markets are emerging as a distinct opportunity in their own right. There is likely room for both of these categories in your clients’ portfolios.
David Sterman is a journalist and registered investment advisor. He runs Huguenot Financial Planning, a New Paltz, N.Y.-based fee-only financial planning firm.