How Advisors Choose Liquid Alts: Reducing Risk, but Watch the Fees

This is the second in a series of blogs exploring the use of liquid alternatives by advisors.

A few years ago, hedge funds were perceived as investments with bond-like volatility and equity-like returns.  That changed with the credit crisis of 2008, which showed that most alternative strategies are vulnerable to the same market whims as long-only investments.  

Hedge funds now have the reputation as a less volatile source of investment returns. This sea change has made the asset class more popular than ever, even though hedge fund returns significantly lag the stock market. 

The utility of alternative strategies as a risk reducer among the RIA community has experienced a similar renaissance, as the use of liquid alternatives – mutual funds that are designed give the same sort of return stream as their less liquid hedge fund kin – have skyrocketed.    

One thing I wanted to discover when doing the reporting for my Investment Advisor August cover story, Alts Are the Answer, was how advisors are choosing alternative funds. Their response to that question reflected the considerable thought used to determine which funds are most appropriate for client accounts.

First, most RIAs aren’t interested in brand-names. They seem more focused on niche firms with demonstrated expertise in a certain area rather than an offering from a long-only behemoth trying to leverage their name in the liquid alts space. Relatively short track records make the selection process a bit more difficult, so many RIAs look to previous LP performance of fund companies to determine if the fit is right. 

Once the quantitative work is done, the qualitative analysis can begin. RIAs typically demand more access to portfolio managers of an alt strategy than for a plain vanilla long-only product. A common objective is to determine if past success in a limited partnership structure can be recreated in a more restrictive 40-Act wrapper. For example, managers who rely on less liquid holdings or generate significant alpha through shorting thinly traded stocks may not have as much success in a mutual fund format. 

Another red flag is for any index-based fund to change its rules, according to many advisors. Such “adjustments” might indicate a lack of conviction, or that the strategy is a product of curve-fitting (i.e., constructed with the benefit of hindsight). 

Fees are an important input, even for strategies that purport to generate significant alpha. So-called ‘top-line’ fees can easily be seen a Lipper or Morningstar report. But there can be another layer of fees, including borrowing costs and fees hidden in swaps, and they have to be uncovered through reading the prospectus. It may be a bit onerous, but many advisors see it as a necessary part of the due diligence process. 

My next blog in this series of posts will examine the drivers behind the boom in liquid alts, and which strategies are most popular with advisors.

Reprints Discuss this story
This is where the comments go.