This is the third in a series of blogs exploring the use of liquid alternatives by advisors, based on reporting conducted among advisors for the August 2014 Investment Advisor cover story, Alts Are the Answer.
One of the main responsibilities of advisors is to match their clients' objectives with appropriate portfolios. Blend in aging demographics and lowered risk tolerance to the equation and what’s the result? A booming market for liquid alternative funds (see U.S. Alt Mutual Fund Asset Market Share to Double by 2015: Cerulli.)
Let’s starts with population trends. More than 10,000 baby boomers turn 65 every day, and will continue to do so for the next two decades, according to the Social Security Administration’s 2012 Annual Peformance Plan. For these folks, the mindset has shifted from portfolio gains to investment income. Also, a more stable net asset value is preferred to ensure that the income stream is not affected by dramatic market events.
The desire for more steady returns is a logical byproduct of the aging demographic. According to the RIAs with whom I spoke for my Alts Are the Answer article, the emphasis on wealth management has shifted to an exercise in risk management. Clients still want some upside participation, according to these advisors, but they also want downside protection. Many clients (and advisors) are concerned that already rock-bottom interest rates will prevent bonds from adding the same amount of diversification as they have in the past.
These new realities set the foundation for a surge in liquid alternative investing. According to a recent McKinsey and Co. report, growth in liquid alt funds will be augmented by the blurring of lines between them and traditional long-only products.
The best examples are long-short and market neutral equity funds that are benchmarked to factor-based long-short indices. These strategies (along with long-short credit funds) have enjoyed a significant chunk of inflows from RIAs.
With all this promise also come perils. Alt funds are coming out at a furious pace. Many advisors are concerned that many of these new entrants are simply watered down hedge funds run by managers with little or no experience (see Barry Ritholtz’s Bloomberg blog, Ritholtz to Alt Fund Investors: Beware ‘Negative Alpha’). As it promised earlier this year, the SEC has started conducting a liquid alt funds compliance sweep, and as I mentioned in my latest blog, How Advisors Choose Liquid Alts: Reducing Risk, but Watch the Fees, it's important for would-be investors to keep a sharp eye on these funds' costs.
Advisors should note that selecting the right liquid alts fund takes more due diligence and monitoring than for a traditional fund. But there are a number of well-designed offerings by professionals with years at the helm, and many RIAs seem to think it’s worth the effort to include them in client portfolio.
Our next blog in this series, Ben Warwick on Liquid Alts, will discuss an interesting way to incorporate managed futures in a portfolio.