Cleo Chang, head of alternative investments at American Century, a $150 billion global asset management firm, agrees that greater industry communication about the merits of these vehicles will be required. “There continues to be growth in assets under management in the category,” she says, “but we need to further the education of advisors about how best to use them.” 

It doesn’t help that the Federal Reserve and other central banks have continued highly accommodative monetary policies, which has distorted traditional risk and reward relationships. “There’s evidence of complacency that has led investors to downplay risks,” says Chang, “which has made it harder for liquid alts to flourish in recent years.” 

To appreciate the merits of liquid alternatives, investors will need to shift away from a traditional focus on annualized absolute returns. Indeed, it is a challenge to track the performance of liquid alts in general, simply because the various alt strategies flourish in different kinds of markets. 

Thus far in 2015, for example, managed futures funds have risen roughly 6%, according to Morningstar, handily outperforming stocks and bonds. Most other categories (such as multi-alternative, market neutral and long/short equity) have posted only modest gains, while “bear market” funds are heading for a double-digit loss this year. Indeed, that category has generated a 21% annualized loss over the past five years, and when you consider that stocks rise in value most years, this category may not have much of a future. 

Broadly speaking, “this year’s performance has been in line with what you’d expect,” says Josh Charlson, director of alternative funds research at Morningstar. Charlson, like many alt strategists, insists that performance shouldn’t be measured by returns relative to stocks, but instead on a risk-adjusted-return basis. Many alt funds are constructed to maintain a fairly low beta, a key measure of volatility. 

While various alt categories tend to offer varying levels of return and volatility, they can be blended together to deliver a portfolio that delivers ideal risk-adjusted returns. That’s the logic behind multi-asset or “multi-strategy” funds, which deploy a basket approach. 

Morton Capital’s Sarti believes that multi-asset funds can be helpful tools for broad-based portfolios. “They bring a lot of diversification to retail investors, but we caution that you really need to understand what you are getting. Many liquid alt funds are simply a mix of stocks and bond positions and carry more traditional market risk than many investors realize,” he says.

Lowell Yura, the portfolio manager of the BMO Alternative Strategies Fund (BMATX), deploys his fund’s assets among a half-dozen specialty sub-advisors. (Some multi-asset funds work with up to 20 sub-advisors, which can greatly dilute the impact of sub-advisor selection). Balancing assets among hedged equity, relative value, hedged credit and global macro enables Yura to retain a portfolio beta in the 0.30 to 0.35 range. 

Yura is quick to note that the fund is not constructed to deliver great bull market results. “The typical investor already has ample stock and bond exposure, so we’re optimizing the right liquid alt approach that can augment the typical 60/40 [stock/bond] construct,” he says, adding that the fund’s sub-advisors don’t rely on economic cycles to deliver their returns. Eliminating market and economic cycle risk is a key consideration these days in light of the fact that we haven’t seen a bear market or a recession in the past six years. 

While many investors focus on the quality of management in their alt funds, some simply seek out the lowest cost options. After all, in many portfolios, alts play a satellite role rather than a core role, and the typical 2% expense ratio of liquid alts can eat away at returns.

Index IQ, which was acquired by New York Life’s Mainstay Investments division in April 2015, offers a low-cost approach, with exchange-traded funds (ETFs) that are built to deliver hedge-fund-like returns with expense ratios below 1%. (That expense ratio looks especially enticing when you consider the “1 and 20” cost burden of many traditional hedge funds.) 

The IQ Hedge Multi-Strategy Tracker ETF (QAI), for example, shifts assets among six alt categories: global macro, long-short equity, emerging markets, event-driven strategies, market neutral strategies and fixed-income arbitrage. “As hedge funds change their allocation, we reallocate our weightings,” says Adam Patti, CEO and founder of Index IQ. “There’s very little alpha,” he concedes, “but it provides a multi-asset beta.” His firm also offers five other ETFs that replicate hedge fund strategies, although the QAI fund is the firm’s top dog, with roughly $1 billion in assets. 

Morningstar’s Charlson is also cognizant of investor concerns about high expense ratios for many alt funds, especially those that aren’t delivering solid risk-adjusted returns. “With this niche, there can be a lot of layering of sub-advisor management fees,” he says. To justify expenses that are higher than those of a typical stock or bond fund, Charlson says it’s crucial to look for fund firms that have a “great deal of experience in terms of selecting underlying managers.” 

In that context, Morningstar assigns a positive rating to the Litman Gregory Masters Alternative Strategies fund (MASNX), which has built a strong reputation for manager selection and portfolio diversification. The fund has delivered the best Sharpe ratio (another measure of risk-adjusted returns) in the multi-asset category, according to Morningstar.

The liquid alternatives niche is still evolving, and though the weaker hands are likely to shake out, further innovation is also likely to take place. “There are so many new ideas out there, and new ways to manage money that go beyond the 60/40 [stock/bond] approach,” says LMCG’s Davis. “I am extremely optimistic that current research is going to yield great new approaches.” 

The fund industry’s challenge is to capture the interest of more retail investors—through better education and, presumably, solid risk-adjusted returns in a potentially tumultuous stock and bond market in 2016.

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