The widespread rollout of liquid alternative funds in the years following the Great Recession was a case of bad timing, leading to perceived poor performance that, in turn, sullied their reputation among investors.
But that was then, and this is now. That said, the point of this article isn’t to imply that liquid alts funds have been magically transformed into whiz-bang products that will answer investors’ prayers. Rather, a new report from financial research firm Morningstar Inc. posits that structural changes among some liquid alts funds, combined with the current market environment and perhaps more realistic investor expectations, could make them a viable inclusion in investment portfolios.
“Alternative investments” encompass a host of different investment strategies designed to smooth the ride over different investment cycles by diversifying portfolios with assets that aren’t correlated to traditional long-only stocks and bonds. In theory, infusing portfolios with different revenue streams can help mitigate drawdowns in bear markets while providing some upside potential across various market conditions.
Problem is, growing investor demand for liquid alts—and the eagerness among financial companies to crank out products to meet and/or encourage demand in the form of low-cost, open-end funds—came after the financial crisis had passed and U.S. equities embarked on their longest-ever bull-market run.
Many investors who added liquid alts funds to their portfolios were disappointed—in part because they compared the total return performance of these products versus equities. But these were misplaced expectations because liquid alts aren’t built to outperform equities during bull markets. Rather, they’re portfolio diversification tools meant to provide a degree of non-correlation to stocks and bonds over a full market cycle.
In its “2021 Global Liquid Alternatives Landscape” report, Morningstar detailed how some liquid alts funds have changed during the past decade, and it listed various reasons why liquid alts might be worth a second look. This report examined liquid alts across various global markets, and in the U.S. it focused on mutual funds and excluded exchange-traded funds.
“Fees have come down over time within this strategy group,” Erol Alitovsky, a liquid alternatives analyst at Morningstar who contributed to the report, said in an interview. “And in some cases [providers] tried to reduce the complexity, or find ways to operate within ’40 Act constraints and still be able to produce some level of idiosyncratic alpha.”
The Morningstar report noted that 2020 returns for the Credit Suisse Liquid Alternative Index were the strongest since 2009, leading to the largest inflows into liquid alts funds—particularly in the U.S.—since 2013.
The non-correlated nature of alternative investments helped boost returns within the broader category last year, when both stocks and bonds tumbled during the depths of the pandemic-fueled market meltdown. The sense that stocks and bonds are increasingly correlated creates an environment where liquid alts can be additive to portfolios, either by themselves or as part of a 60/40 portfolio, according to the report.
New Framework
In the report, Morningstar analysts suggest that investors can set appropriate expectations for liquid alts by grouping them based on their objectives, volatility profiles and targeted risk components.
One grouping contains “modifiers,” which consist of long-short equity, derivative income, nontraditional/flexible bonds and tactical/flexible allocation strategies. These typically have been lumped into the alternatives bucket, but Morningstar analysts believe they don’t belong there.