October 9, 2013

Liquid Alts, Pt. 1: The Long and the Short of Them

Liquid “alternative” investment strategies have been among the most popular but least understood investment innovations of recent years.  Liquid alternatives burst upon the scene in 1997, after an obscure but important rule governing mutual funds—the short-short or 30% rule—was repealed as part of Bill Clinton’s Taxpayer Relief Act of 1997.  Repeal of the rule made it more practical for mutual funds to engage in short-term trading and short selling, ultimately opening the floodgates for mutual fund and ETF strategies that emulate hedge funds. 

In the last three years, alternative mutual funds and ETFs have gathered $60 billion of assets, and the category as loosely defined by Morningstar has reached $120 billion in assets. 

Wealthy investors and endowments historically have invested in hedge funds to enhance returns or to reduce portfolio risk. In recent years, Yale’s success investing in hedge funds and private equity has influenced the investment strategies of many advisors, while individual investors have been drawn to the eye-popping returns of the hedge funds that were big winners before or after the financial crisis. 

Interest in hedge funds that provide downside protection is also a natural response to the financial crisis, as traditional investments thought to provide diversification failed to protect portfolios during the bear market. Consequently, individual investors have wanted a way to participate in the action, and increasingly are turning to liquid alternatives as the vehicle to do so. Previously, individuals have used liquid vehicles to follow their institutional counterparts in formerly exotic investments such as real estate, emerging markets equities and commodities; liquid alternatives are the next chapter in that story.

The benefits of liquid alternatives in comparison with traditional hedge funds are compelling. Liquid alternatives, whether in mutual fund or ETF form, provide easy and low-cost access to traditional hedge fund strategies. Liquid alternatives offer daily liquidity, have low minimum investment requirements, and provide more investment transparency and regulation than traditional hedge funds.

As Rick Lake of Lake Partners puts it, liquid alternatives provide a “kinder and gentler” way to invest in hedge funds.

What Are Liquid Alts?

Liquid alternatives cover a wide range of investment strategies that don’t fit neatly into a single classification.  Morningstar defines alternatives as investments that fall into one of three categories:

  • Non-traditional asset classes, such as futures and currencies. 
  • Non-traditional strategies, such as short selling or hedging.
  • Illiquid assets, such as private equity, private debt or distressed debt.

Some strategies aim to be fixed income alternatives by providing bond-like returns and risk, while other strategies are more equity-like from a risk-return perspective. It’s important to understand the objective for each alternative investment strategy, and to understand the approach taken to achieve the objective. 

In our view, the primary alternative strategies are long-short equity, event-driven, long-short bond, and macro.

The remainder of part one of this column will review long-short equity strategies and event-driven strategies. 

Long-Short Equity Strategies

Long-short equity strategies include long-biased strategies such as 130-30 (a strategy in which a manager invests 130% of the portfolio in long investments while having short positions equal to 30% of the portfolio) as well as strategies that typically hold more long positions than short positions, but have less than 100% market exposure. 

Long-biased strategies typically are used in equity allocations, providing exposure by either taking advantage of a manager’s ability to identify both long and short selling opportunities or by providing equity exposure that is designed to be less volatile than that of the market. Many of the strategies are promoted as providing less risk than the market, though they are still directionally correlated with the market. 

Equity market neutral funds invest in offsetting long and short positions, hedging market risk while providing absolute returns designed to be independent of the direction of markets. Many market neutral managers utilize quantitative strategies to identify long and short positions in equities and their derivatives with offsetting risk characteristics.  Market neutral strategies are often used as fixed income substitutes, as the risk/return profile provides bond-like attributes while diversifying portfolio risks. 

We are supporters of the conceptual reasoning behind equity market neutral strategies, but caution investors to understand that a manager can at times be wrong about both the long side of a trade as well as the short side, creating risk that, though theoretically uncorrelated with the market, can still carry a significant risk of capital loss.

Short selling or bear market strategies have a net short position and are designed as portfolio hedging tools. Many bear market funds are more suitable for short-term trading than for long-term ownership. 

Event-Driven Strategies

Event driven strategies include merger arbitrage, activist and restructuring-oriented investments.  Merger arbitrage strategies are easier to provide in liquid form and represent the majority of event-driven assets offered in 1940 Act products.  Activist and restructuring-oriented investment are more difficult to deliver in registered products, as the concentration or illiquidity found in the typical private hedge fund product is harder to replicate in a mutual fund or ETF.

Merger arbitrage strategies typically invest in stocks that are the target of an announced stock for stock transaction, while selling short the stock of the acquirer. Some aggressive merger strategies will also invest to take advantage of unannounced but suspected transactions based on investment research. In all-cash deal,s merger arbitrage funds buy the target stock while shorting calls of the acquirer. Conceptually, merger arbitrage investors seek to capture the premium paid for the target. 

Merger arbitrage strategies are often used as fixed income substitutes, providing steady risk-adjusted returns in normal market environments. Merger arbitrage strategies can struggle in times of crisis when deal flow dries up, when deals are more likely to fall through or when financing costs unexpectedly rise.  

In part two of our series, we’ll look discuss long-short bond strategies, macro strategies, and provide some thoughts on how to select a liquid alternatives product.

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