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.