From the April 2012 issue of Investment Advisor • Subscribe!

March 26, 2012

The Case for Liquid Alternatives in Mutual Funds

A liquid alternatives mutual fund offers the potential for diversification and return enhancement similar to that of a traditional hedge fund.

Historically, alternative investments, such as hedge funds, have offered return enhancement, risk mitigation and correlation benefits to a diversified investment portfolio, but many investors have been unable to access these investments due to high minimum investment hurdles and high qualification standards. Even those who overcome these obstacles face subsequent illiquidity, special tax procedures and opaque investment reporting. As a result, advisors have only been able to provide the potential benefits of alternatives to a select sub-set of their client base.

The solution for a more broad-based asset allocation model lies in “liquid alternatives.” Liquid alternative mutual funds may offer liquidity, low investment minimums, no investor qualification standards and the general ease and familiarity of mutual fund structures.

The growth and availability of liquid alternative mutual funds also allow advisors to rebalance client portfolios at appropriate intervals. Efficient rebalancing offers advisors the flexibility to use alternatives within model-based portfolios as well.

The Challenge

The challenge is how to introduce hedge fund behavior—such as risk mitigation and increased diversification—into a liquid portfolio of traditional asset classes. Many existing choices are single-strategy, single-manager mutual funds, and selecting appropriate single-strategy hedge fund managers is a labor intensive process.

In lieu of investing in one specific hedge fund strategy, some advisors have chosen to create a basket of varying single-strategy, hedge fund-like mutual funds. Additionally, over the last few years, funds have been developed to incorporate multiple managers within one fund or portfolio. Regardless of which direction investors pursue, rigorous due diligence is required.

Investment Strategies

A liquid alternatives fund that allocates to a broad range of hedge fund strategies offers the potential for diversification and return enhancement similar to that of a traditional hedge fund. It also provides exposure to various underlying hedge fund strategies in a structure that provides the daily liquidity and portfolio transparency of mutual funds registered with the Securities and Exchange Commission (SEC). In a multimanager or “fund of funds” approach, managers also add value through active strategy and manager allocation decisions in a defined process.

Well-constructed, diversified investment programs can now include alternative investments regardless of an investor’s near-term liquidity constraints. Advisors appreciate that rebalancing may occur when desired. In traditional, liquid portfolios, advisors have been able to offer periodic rebalancing to ensure adherence to a predetermined asset allocation mix. The constraints of longer lock-up periods and less frequent liquidity periods made timely and appropriate portfolio rebalancing quite difficult for advisors. The introduction of hedge fund strategies in a mutual fund structure allows for such benefits.

Many advisors utilize model-based investment programs for certain types of clients. Within such a model, centralized asset allocations are made that automatically alter a group of investors’ portfolio allocations. In these programs, traditionally structured alternative investments may be inefficient because of the aforementioned liquidity constraints. Today, liquid alternative mutual funds offer a solution whereby model-based investing can still offer its efficiency and broad scale, while also delivering the potential benefits of hedge fund investing.

Liquid alternatives enable advisors to rebalance on a regular, strategic basis or utilize the efficiency of model-based programs, while delegating the associated search, selection, due diligence, portfolio construction and risk management activities to full-time, experienced professionals.

We believe that investors should use a diversified pool of liquid alternative strategies in conjunction with exposure to more traditional hedge fund structures as a core allocation in an overall asset allocation program. Hedge fund strategies have offered superior risk-adjusted returns versus long-only strategies over the last two decades, and therefore, we believe they should play an important role in portfolio allocation going forward. The growing universe of liquid alternative strategies gives investors the opportunity to increase their exposure to hedge fund strategies and receive many of the potential risk/return benefits without compromising liquidity.

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