From the October 2012 issue of Investment Advisor • Subscribe!

September 25, 2012

Alternatives Go Mainstream

Alternatives can play defense as well as offense.

The 2008 financial crisis accomplished in 12 months what I have been trying to do most of my 26-year career: educate investors about the benefits of allocating some of their portfolio to alternative investments, in particular, hedge funds and managed futures.

One of the great truisms of investing—“If you lose 50%, you need to make 100% just to get back to even”—goes a long way toward explaining why 2008 was so effective in stirring up interest in alternative investments. Even though hedge funds lost an average 19% that year, their performance was a lot better than S&P 500’s 38% trip south. Some managers within popular hedge fund strategies, like global macro, actually made money. Managed futures turned in a glowing performance, up close to 16%.

The events of 2008 sharpened investors’ understanding of the importance of liquid, non-correlated returns. In the process, it transformed the image of alternatives from shadowy, swing-for-the-fences vehicles for the one-percent into powerful risk management tools for conservative investors. Linking “conservative” and “alternatives” sounds as incongruous as “steak” and “vegan,” but investors got the message that alternatives can play defense as well as offense. The new look of alternatives is a welcome and long-overdue change. (Endowments like Yale’s and Harvard’s were early adapters of alternatives and have invested billions, but they have advantages over individuals: They invest for the very long term and have full-time staffs to evaluate managers.)

I don’t know if this search for double-digit returns, coupled with the new desire for non-correlated returns, will result in the assets of hedge funds (also called private funds) doubling in five years to $5.1 trillion, as Citigroup predicted in a June survey. What I do expect is that a much broader range of investors will gain access to this asset class through liquid alternatives.

Liquid alternatives give all investors access to a huge range of alternative strategies that were previously closed to them. Whether they use alternative mutual funds or alternative ETFs, both potentially offer investors the best of the traditional and alternative worlds. They blend alternatives’ history of strong, risk-adjusted returns, opportunistic and flexible strategies, and lower volatility with the advantages of mutual funds and ETFs. Those pluses include daily liquidity, low investment minimums, transparency and relatively lower fees.

Alternative mutual fund assetsAs the accompanying chart shows, assets in liquid alternative mutual funds took off after 2008. As of March 2012, they totaled $99 billion, a 138% increase since October 2008. 

Alternative ETFs have attracted even more assets, about $144 billion by Morningstar’s last count. My preference, not an unbiased one, is for liquid alternative mutual funds. Let me spell out the differences.

Liquid alternative ETFs are index-based--there is no active management. Some alternative ETFs try to replicate familiar hedge fund strategies like long-short, global macro or managed futures, but many more try to track esoteric strategies, such as holding a basket of securities focused solely on dampening volatility. Like all ETFs, investors can trade intraday. Liquid alternative ETF fees range from 35 basis points and up.

Liquid alternative mutual funds offer quarterly or semi-annual transparency and daily liquidity, and because they are actively managed, they charge more than ETFs, up to 3% of assets under management. I’m biased in favor of active management. The whole point of investing in alternatives is that you believe active managers can add value, or alpha. Why not extend that same philosophy to the picking of managers?

Unlike ETFs, liquid mutual funds actively manage the managers, constantly selecting and deselecting managers on the basis of talent. Based on a career of investing with hedge fund and managed futures managers, I believe active management at both levels—picking the manager and picking the underlying securities--is worth paying for, especially in the alternative space.

The problem is that not all active managers are created equal, and their strategies can go in and out of favor. In the words of Warren Buffett, “It’s only when the tide goes out that you learn who’s been swimming naked.” When the tide went out in 2008, a lot of alternative managers were using excessive levels of leverage, were heavily long-biased, or could not offset the impact of global, macroeconomic events on their portfolios. Importantly, investing in alternative mutual funds leaves the extremely difficult task of manager selection to experts.

Alternative investment managers are willing to abandon important tools of their trade, like two-year lock-ups, gates, excessive leverage and lucrative fees because they have their eye on the $ 11.6 trillion now sitting in U.S. mutual funds. (Look for big mutual fund sponsors to start offering versions of liquid alternatives.)

In a world where “risk-free” yields are so low and investors are still skittish about equities, liquid alternatives may be the asset class that, through diversification and non-correlation, helps to solve their problems.

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