You can almost feel the palpable sense of relief among the fund managers that operate in the liquid alternatives (“liquid alts”) category. Choppy stock and bond markets that first appeared in the summer of 2015 have finally created a more favorable backdrop for these funds.
Liquid alts follow hedge fund-style capital preservation strategies while still seeking absolute positive returns. And recent performance bears out a modest renaissance. As a broad proxy, the HFRI Fund Weighted Composite Index has risen for three straight months (through February 29). If such market conditions persist throughout 2016, then these funds may finally post the strong risk-adjusted returns that many of their backers have been waiting for.
Make no mistake, it’s been a difficult multiyear stretch for these funds, as unprecedented actions taken by the Federal Reserve produced a spectacular secular bull market for traditional stocks and bonds, preventing traditional alternative asset strategies from performing as expected.
But the backdrop is improving. “Now that the Fed isn’t playing as central a role in markets, some liquid alts strategies are again showing the kinds of benefits that have historically led to impressive risk-adjusted and non-correlated returns,” says Matt Osborne, chief investment officer of Altegris Advisors.
For investors that like the general approach of hedge fund strategies, but wince at the “2-and-20” fee structure, liquid alts are clearly a better deal. According to Wei Ge, a senior researcher at Eaton Vance’s Parametric Portfolio division, traditional hedge fund management fees will consume 85% of all investor returns over a 50-year time frame. The average liquid alt fund fee, in contrast, would eat up just 21% of returns.
Returns All Over The Map
Still, investors are cognizant of the troubled recent past for liquid alts. “On average, many of these funds didn’t deliver the kinds of returns that many had been expecting,” says Jack Hansen, chief investment officer for Parametric’s Minneapolis Investment Center. Even in the relatively healthy market backdrop of the last six to eight months, many liquid alt funds continue to deliver negative returns, albeit less negative than the equity market.
That performance issue, coupled with a surplus of products in an increasingly crowded field, is leading to a modest industry shakeout. While an average of 91 new liquid alt funds were opened each year from 2011 through 2015, fund closures have become the more recent theme. In 2015, 149 of these funds were shuttered, and we’re seeing elevated rates of fund closures again in 2016, according to Morningstar.
It may not be wise to lump all of the liquid alt funds together. Returns among the various sub-categories have greatly varied, and some of them may not be suitable for the liquid alt approach.
Take the unconstrained bond fund category as an example. Hedge funds are able to expertly navigate these assets, even though they can often be illiquid and require lots of leverage to generate returns. In that context, “these kinds of alt funds just don’t translate very well,” says Osborne.