The Meta-Analysis Managers
To deliver category-beating returns, fund managers often need to take a very distinct approach. The fund advisors at AlphaSimplex LLC look to profit from investor behavior in the various asset classes the firm manages. The firm’s core principles were developed by Dr. Andrew Lo, an MIT professor who built what the firm calls an “adaptive markets hypothesis.”
“We’re looking for behavioral biases that can justify momentum and trends in markets as investors adapt to new information,” says Duncan Wilkinson, the firm’s CEO. For the firm’s ASG Managed Futures Strategy fund (AMFAX), 70 different futures contracts (spanning stocks, bonds, commodities and currencies) are studied for key trends, which can be driven by “fundamental factors or simply by fear or greed,” Wilkinson notes.
“We want to know how the market is reacting, and we want to measure the risk” embedded in futures contracts. “We don’t try to predict a trend; we just try to follow it,” he adds.
That form of market meta-analysis has paid off nicely. The fund has racked up a 6.44% annualized return since 2010, compared with 0.44% in the managed futures category, Morningstar says. It’s also notable that the fund has a near zero correlation with the S&P 500. In all, AlphaSimplex manages five liquid alt funds with a combined $7 billion in assets for France’s Natixis Global Asset Management.
The Long/Short Formula
Since the S&P 500 has been flat for the past 12 months, this should be an ideal time for long/short funds to shine. But that hasn’t been the case for most. The average long/short fund is off 7.5% in the past year. Only AQR Capital Management, Otter Creek Advisors, Boston Partners and LJM Partners have managed to deliver gains of at least 7.5% in their long/short funds in the past year.
Here’s an area where a sound set of investment principles are needed to underpin long-term fund performance. “We’ve been focusing on long/short funds since 1998, long before liquid alts were even a category,” says Jay Feeney, co-CEO and chief investment officer of Boston Partners. His firm runs long/short funds focused on the U.S., developed markets and emerging markets. The Boston Partners Long/Short Equity Institutional fund (BPLSX) fund has returned 8% over the past year, and garners five stars and a Bronze rating from Morningstar.
Most managers will suggest that success in this category is as simple as finding overvalued and undervalued stocks. “That’s a losing approach,” says Feeney, noting that stocks with high valuations can maintain their momentum for an extended period.
He thinks a much deeper set of investing factors must be used. Boston Partners focuses on three key traits for its long positions: the company must have an attractive valuation; it must have quality cash flow paired with favorable capital deployment; and it must have underlying business momentum such as upward sales revisions.
On the short side, Boston Partners seeks out what it calls “failure characteristics,” which Feeney highlights as high valuations, poor cash generation (paired with weak balance sheets) and deteriorating business momentum. Broadly speaking, the long positions are typically large caps while the short positions are primarily small and mid-cap companies.
Feeney and his research team also avoid the trap that many managers fall into when they build a very large position in a long or short “high-conviction” pick. “We do not believe in concentrated positions. It’s too easy to have a blowup that way,” he adds. The fund has more than 400 positions, and no position accounts for more than 2.5% of the fund.
Liquid Alts In An ETF Wrapper?
Underwhelming investment returns have been a key challenge for the liquid alt industry. To be fair, many of the liquid alt funds are merely mirroring the equally tepid returns of their hedge fund counterparts. That can be chalked up to a market environment that seems to have solely favored stock and bond bulls in recent years. Liquid alts are at least a better bargain than the many “two and 20” hedge fund fee structures.
That doesn’t mean the liquid alt funds are clear bargains either. That’s why some firms are beginning to think about liquid alt strategies with much lower fees, the kind found in exchange-traded funds.
At the end of 2014, in a bid to sidestep the crowded liquid alt field, New York Life Insurance Co. acquired Index IQ, which had built a series of liquid-alt style funds. That firm’s IQ Hedge Multi-Strategy Tracker ETF (QAI), for example, has garnered four stars from Morningstar and has more than $1 billion in assets.
Adam Patti, the CEO of Index IQ, seems thrilled at the chance to link up with a large firm like New York Life. “Until a year ago, we had no distribution and little marketing budget,” he says, adding that the distribution support now in place is helping many of Index IQ’s other liquid alts-style funds increase their assets at a more rapid pace.
It’s notable that in April 2016, Hedgeweek named Index IQ’s Multi-Strategy ETF the “Best ’40 Act Liquid Alternatives Fund.” It was a wake-up call for the industry, which has largely skirted the issue of somewhat high fees and largely ignored the world of ETFs.
New York Life’s decision to buy into an ETF platform to become a bigger player in liquid alts may portend additional moves by major players that feel the need to respond to the fee-related concerns. One thing is for sure. This is an industry that is still evolving in search of the right approach with advisors and investors. The industry growth thus far has been impressive, but the next half-decade may require bolder product offering strategies and enhanced investor education.