It’s time for some soul-searching in the financial services industry. Over the past five years, dozens of firms have collectively launched hundreds of alternative investment funds, known as “liquid alts,” yet many potential clients continue to steer clear of this emerging asset class. Blame for the disconnect goes to a case of lousy timing and a key misconception. Yet the year ahead promises a brighter outlook for liquid alts, and fund marketers are redoubling their efforts to highlight the asset’s appeal.

Make no mistake, the torrid post-recession rally in stocks and bonds created a lousy backdrop for liquid alts. They are built for hedge fund-style strategies, emphasizing capital preservation as much as capital gains. While investors reaped an impressive 14% annualized gain with stocks in the five years ended 2014 (and garnered solid gains in bond funds as well), most alternative funds have delivered modest gains, and some have delivered outright losses. 

Yet as investors again learned in 2015, stock and bond prices don’t always head north. And when bull markets come to an end, alternative investments can really shine. Indeed, such assets provided important stability to portfolios in periods of turmoil, like we saw in 1998 and 2000 and again in 2008.

Outsized gains in those years have enabled alternative investments to largely keep pace with stocks. According to Hedge Fund Research Inc. (HFRI), stocks have risen an average 0.79% per month in the 20 years ended 2014. Alternative investments have posted a 0.70% monthly gain in that time. Considering how massively stocks outperformed alts in the final five years of that analysis, it becomes apparent that alternative investments fared quite well in the prior 15 years. 

More to the point, alternatives have delivered respectable long-term gains with much lower volatility. Over the 83 down months in the 20-year period, stocks fell an average of 3.87%. Alts fell by just 1.07%, according to HFRI. Said another way, the stock market’s wild swings over the past 20 years have produced a standard deviation of 15.5% according to Invesco, while alternatives have had a standard deviation of 5.7%. 

In the past, bond funds typically provided a source of lower volatility for portfolios. But after a remarkable rally that dates back to 1982, bond yields may be headed up and bond prices may be headed down in coming years. “Bonds may not act as the ballast they historically have,” predicts Jeff Sarti, co-president of Morton Capital Management.

A Looming Shakeout?
To be sure, the liquid alternatives segment is ripe for an overhaul. Thanks to an aggressive slate of new product offerings over the past few years, there are now 642 liquid alt funds, according to Goldman Sachs Asset Management. Many of those funds lack enough assets under management to remain viable for their fund sponsors, and the coming year may represent a tidal shift in terms of fund closures. “There’s no way to sustain the number of funds that are out there. Many of them won’t survive,” says Jeff Davis, chief investment officer at Boston-based LMCG Investments and manager of the LMCG Global MultiCap Investor fund (GMCRX). 

Ahead of any sort of potential industry shakeout, investors should focus on the strongest offerings in the various liquid alt categories. “This is a really good time to start comparing alt funds, as many of them have now produced three-year returns,” says LMCG’s Davis. 

Still, many investors aren’t equipped to make a thorough assessment and are still moving up the learning curve with these assets. “People are struggling to grasp the key issues such as correlation (with stocks and bonds), performance in various markets and the role of alts,” Davis adds.

Helping investors to understand the merits of liquid alts remains an unmet challenge for many fund sponsors. Some fund firms, such as AQR, Invesco and American Century Investments, are building out more product research on their websites, though more work needs to be done. “The real innovation needs to come from the academic side, which would be helpful for people to better understand these funds,” says Davis. 

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