Investors aren’t as thirsty for liquid alternative mutual funds and ETFs as they were in the years immediately following the financial crisis. According to Morningstar, total net assets in these funds, which rose from around $74 billion in 2010 to more than $178 billion in 2014 amid a proliferation of new products, have stabilized and even shrunk a bit.

“Generally, demand for alternatives is not great in the case of prolonged bull markets like this,” says Tayfun Icten, an analyst in the multi-asset and alternatives group at Morningstar. With equities pretty much trending straight up for eight years, he says, people are less inclined to seek the three things they expect from alternatives: unique return drivers, uncorrelated returns and some downward protection.

Their performance hasn’t helped their popularity either. While it’s unreasonable to expect alternative strategies, on aggregate, to outperform equities in this market, he says, “At the end of the day, I would expect, as an alternatives analyst, to see better risk-adjusted returns, better bang for the buck, when you invest in alternatives.”

One problem is that managers who can’t find enough alpha-driven opportunities for their ballooning assets are parking more money in cash, where returns are nearly nonexistent. Low interest rates have also compressed risk premiums, which is challenging such strategies as merger arbitrage and convertible arbitrage, he says.

But investors should be paying more attention to liquid alts, particularly if they anticipate a rapid rise in interest rates, unexpectedly high inflation or increased volatility in the equity and bond markets. Such risk factors “would probably produce a better opportunity set, more fertile ground for alternative funds,” says Icten.

Jeff Davis, chief investment officer of Boston-based LMCG Investments LLC, agrees. “In the rearview mirror, liquid alts do not look good at all,” he says, because anything diversified away from credit risk, duration risk and equities has performed very poorly. However, “It’s probably just about the time to be thinking very seriously about a larger commitment to liquid alts,” he says.

The big issue, he says, is that the standard allocation of 65% stocks/35% bonds may not be sustainable much longer. Stocks (especially U.S. stocks) and bonds (including Treasurys) are arguably close to peak valuations, historically, he says.

By December 2016, U.S. stocks were already pricing in the beneficial effects of long-lasting tax reform on company earnings and capital formation, he says. But, he adds, it’s still hard to say whether the reforms promised by President Trump and the Republican Congress will actually happen, he says.
For now, “Trump leads to high valuation, high valuation is risk, [and] risk leads to the need for diversification, which leads to liquid alts,” he says.

People who’ve been richly rewarded by investing in index funds also need to realize the S&P 500 is “dominated in a very concentrated way,” he says, by the technology giants. Its top 10 components by index weight include Apple, Microsoft, Alphabet, Amazon and Facebook. “You have a point where winners are taking all and that’s usually an unsustainable period of time,” he says.

He notes that during the tech bubble collapse of 2000 and 2001, active managers employed a variety of strategies (market neutral, global macro and directional long-short) that performed much better than the indexes.

Additional Appeal
Michelle Borré, the sole portfolio manager of the Oppenheimer Fundamental Alternatives Fund and the lead portfolio manager of the Oppenheimer Capital Income Fund, also sees valuation risk as a key reason to consider liquid alternatives. Stock market valuations are pretty high, there’s been little earnings growth over the last couple of years, and the cyclically adjusted price-earnings ratio is high, she says.

“From these levels, the next 10 years of equity returns have generally been pretty low, if you look back over 100 years,” she says.

Using liquid alts on the fixed-income side also makes sense to Borré. The yield to maturity for bonds is too low to mathematically expect fixed income to rally strongly as it has over the past 35 years, she says. She also thinks it’s important to reduce duration exposure—the sensitivity of bonds to interest rates.

Rates will rise if the economy gets a boost from deregulation, tax cuts, repatriated capital and increased infrastructure spending, she says. She also notes the people being floated to fill vacancies and expiring terms at the Fed are much more hawkish than dovish (favoring tighter monetary policy rather than historically low rates).

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