The proliferation of liquid alternatives (also known as alternative mutual funds) has attracted a lot of attention from institutional investors lately — and retail investors are beginning to take notice too. In view of liquid alternatives’ complexity, however, the popularity of these funds presents a case in which product innovation appears to be outpacing investor education. It’s important to close the gap — a goal the Securities and Exchange Commission seems to share, with its recently initiated review of liquid alternatives. As with any new investment product, investors need to do their homework to understand the benefits and risks of these strategies.
Liquid alternatives are available through investment vehicles such as closed-end funds, exchange-traded funds and mutual funds that provide daily, weekly or bimonthly liquidity with pricing each day. Their portfolios and strategies — such as global macro, multistrategy, event-driven and equity long-short — resemble those of traditional alternatives, like hedge funds, and pursue similar trading methodologies. In the U.S. these investment vehicles are referred to as 40 Act (after the Investment Company Act of 1940) funds, and in Europe as UCITS (Undertakings for Collective Investment in Transferable Securities).
A principal objective of liquid alternatives is to produce differentiated returns that diversify traditional asset classes, like stocks and bonds, while smoothing volatility in portfolios. To accomplish these goals, the investment manager utilizes the levers of alternative investing — namely leverage, shorting and illiquid securities — all wrapped up in a vehicle that provides high levels of governance, transparency and tax efficiency. With no performance fees, these funds can also offer more advantageous fee structures compared with the steep 2 percent management and 20 percent performance fees that are typical of traditional alternative-investment vehicles.
Because traditional alternatives offer limited liquidity and transparency and entail higher levels of risk, they have historically been restricted to institutions and high-net-worth individuals. In addition to the growing role of liquid alternatives in institutional investment strategies, however, their status as publicly traded funds now makes them available to mainstream investors too.
By some estimates, global liquid alternative assets under management totaled approximately $700 billion as of the end of the first quarter, up 30 percent over the past year and more than double the asset level of just five years ago. By 2023 liquid alternatives may account for as much as 14 percent of total mutual funds assets worldwide.
Several factors are driving today’s growing interest in liquid alternatives:
- The search for higher yield is drawing attention to the potential of uncorrelated assets to improve overall investment results.
- As volatility continues to affect traditional markets, investors are seeking ways to stabilize their portfolios.
- With memories of the financial crisis still strong, investors want greater transparency about investment vehicles, strategy and risk.
- Liquid alternative fee structures look increasingly attractive to investors concerned with investment costs.
The shift toward liquid alternatives also reflects the impact of recent regulatory changes. For example, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act requires advisers that have assets under management in excess of $150 million to register with the SEC. Qualifying as an accredited adviser also has become harder under the act. Meanwhile, the European Union’s Solvency II directive will result in stricter investment controls and higher risk-weighted capital charges for insurers’ allocations to illiquid investments, such as traditional alternatives. These changes are enhancing the appeal of liquid alternatives.
Yet given their advantages, how well are liquid alternatives actually performing? To measure their potential benefits, we at State Street recently looked at how these investments might have improved the risk-adjusted performance of a traditional balanced portfolio. Specifically, we wanted to compare the performance of a hypothetical portfolio evenly split three ways among stocks, bonds and a liquid alternative fund with the performance of a portfolio evenly allocated between only stocks and bonds.
Our findings showed that since January 2011, most liquid alternative funds would not have improved the hypothetical portfolio’s performance. This shouldn’t be surprising, however: In a significant bull market like the one during this period, allocating money away from equities would, on average, not have represented a winning strategy.
By contrast, when we focused on periods of decline in the S&P 500 index, we discovered that 60 percent of the liquid alternative funds would have had a positive impact and, in some periods, even more so. For example, when the U.S. credit rating experienced a downgrade in 2011, 84 percent of the market-neutral funds would have reduced the hypothetical portfolio’s losses, had they been included.
Even beyond their specific characteristics and potential track record, liquid alternatives have two conceptual advantages that very much influence how investors are thinking about them today. First, they have lifted a constraint on retail investors, who, before these funds entered the market, were effectively excluded from participating in alternatives-based investment strategies. Second, they offer investors considerable flexibility for using liquidity to rebalance their portfolios according to their investment targets or to shift allocations as desired.
Both of these advantages, along with liquid alternatives’ other features, represent opportunities for investors seeking relief from today’s investment challenges. Of course, as with all investment strategies, these funds also underscore the importance of being informed. In the case of liquid alternatives, investors would be especially smart to pay heed to another piece of advice: Let the buyer beware. Despite their differences when compared with traditional alternative-investment vehicles, liquid alternatives present higher risk factors, such as the use of leverage and derivatives, than do conventional mutual funds. As investors consider whether liquid alternatives make sense for their portfolios in light of their particular investment goals, they should educate themselves about and monitor the risks that underlie these funds.
For example, it’s critical to be familiar with a fund’s investment structure and to identify the risk elements it presents. Because liquid alternatives require subadvisers, they also require active management, calling for investors to focus carefully on the subadviser’s suitability and experience. Investors should also understand a fund’s expense ratio and the components of its fee structure to determine the potential impact on performance.
The UCITS alternatives market already provides a useful opportunity to review lessons learned from liquid alternatives’ track record so far in Europe. These risk-related lessons, addressed in UCITS V, emphasize the importance of ensuring independent and conflict-free depositaries with custody of a fund’s assets; tightening up due diligence rules for depositaries clarifying compensation policies for fund managers; and revisiting sanctions for violations. Custodial safekeeping of assets is also an important requirement of the 40 Act, resulting in higher costs for unsecured financing.
Investors can benefit from risk analytics tools tailored to liquid alternatives based on their unique features and the specific requirements of each portfolio. This is especially important given the inadequacy of risk measures applied to conventional investments. Given the steep growth in liquid alternatives and the need for educated investors, the SEC’s announcement that it is conducting a coordinated review of these funds and their managers is well timed. Investors can expect the SEC to focus on valuation of illiquid securities, liquidity, leverage and disclosure, and its review might possibly open the door to a definition of best standards and common working practices.
As an investment strategy attuned to today’s investment landscape, liquid alternatives look as if they’re here to stay. How well they perform for institutional and retail investors, however, depends in large part on how well they’re understood and how carefully the investor appreciates, measures and responds to their inherent risk.
John (Jack) Klinck Jr. is executive vice president, head of global strategy and new ventures for State Street Corp. in Boston.
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