An alternative to alternatives: liquid mutual funds

On paper, these new mutual funds fix many of problems often associated with the traditional hedge fund structure. 

The liquidity of a daily liquid mutual fund is attractive to investors who do not want to lock up their capital.  Further, their access is greatly enhanced as these funds are often carried on mutual fund and broker platforms, have no minimum net worth requirements and can be accessed for thousands of dollars rather than millions. 

Given the regulations applicable to mutual funds, transparency is often greater and strict mandates are placed on leverage, concentration, investment focus and holdings.  Finally, these funds, while more expensive than traditional mutual funds, are generally cheaper than a hedge fund. 

The mutual fund’s liquid structure may not be appropriate for all asset classes.

Although retail liquid alternatives answer some of the objections to hedge funds, the liquid structure raises its own concerns.  While daily liquidity is often a strong selling point, many asset classes and investment styles are not appropriate for daily liquidity. 

The stocks of micro and small companies, frontier and emerging market equities, privately traded stocks and bonds, and smaller high-yield bonds/bank loans are examples of securities that would be difficult to trade as frequently as may be needed to match a mutual fund’s daily investor flows.  In the event investors were buying or selling heavily, this “asset/liability mismatch” between the fund’s underlying investments and its investors’ demands would result in liquidity pressure that could push down the prices of the portfolio’s investments.

For example, if investors were buying heavily into a fund, the manager might have a hard time putting the money to work in these less liquid securities.  The result could be an opportunity loss. Worse yet, if investors were selling heavily out of the fund, the manager could be forced to sell these less liquid securities quickly or at inopportune prices, resulting in heavy losses. 

An argument can be made that these alternative funds inherently have a “negative selection” effect.

Whether launched as a single-manager fund or multi-manager fund, the evaluation of the manager(s) and their motives for launching the product is important.  An argument can be made that these funds inherently have a “negative selection” effect – the potential for the “best and brightest” hedge fund managers to continue managing hedge funds, while less-proven managers end up managing these daily liquid strategies.

Why would an established hedge fund manager who has a strong performance record and who is getting paid a 1.5 to 2.0 percent management fee on assets, plus an additional 15 to 20 percent fee on the performance generated by the hedge fund, be willing to offer a mutual fund for a much lesser fee?  In our experience, the answer is often that the liquid fund manager is young and emerging, with a track record too short and assets under management too small to attract an institutional following. 

Is historical performance of the traditional hedge fund representative of what to expect going forward in the new mutual fund?

When examining these new alternative funds, our additional diligence items include an assessment as to whether the presence of the new daily liquid vehicle will alienate the hedge fund’s existing investors, driving them to the lower-fee, more liquid mutual fund. 

Is historical performance of the traditional hedge fund representative of what to expect going forward in the new mutual fund?  Will this proliferation of products be a distraction from the investment manager’s focus?  Which fund(s) gets trading allocation priority when there is a new stock to buy or short or when selling a stock they both share? Through our ongoing due diligence, we have found managers where a daily liquid strategy can work and others where it cannot.  There are some very high quality, established managers who can offer their time-tested hedge funds strategies (or a similar variant) in a daily liquid fund format and have legitimate reasons for the product expansion. 

Many established hedge fund managers have concentrated client bases comprised of large foundations, endowments and pensions and are looking to diversify their assets to appeal to high net worth individuals or retail investors.  Additionally, many hedge fund managers see the daily liquid opportunity as the next direction for the industry and want to be involved early as a way to grow assets and make their firms more resilient from any negative impacts on the traditional hedge fund industry. 

Conclusion

Daily liquid alternatives have appealing characteristics, and we will continue to evaluate each new opportunity.  As the daily liquid alternatives industry has grown, we have started to see a few high quality investment managers capable of managing hedge fund-like mutual funds and who understand the potential conflicts and liquidity issues often associated with this business decision.

However, thus far we have seen very few, and the proliferation of these funds is concerning because many retail investors do not have the resources of an investment advisor skilled in hedge fund evaluation.  Meanwhile, over the last five years, many managers of traditional hedge funds, facing pressure from investors, have become much more transparent.  They are offering more attractive and better balanced liquidity, and have started to reduce fees — addressing some of the objections that have made the hedge-like mutual funds such an appealing alternative.

Investing in the best portfolio managers, who will deliver the best risk-adjusted net return after fees, in a fund structure that most closely matches an investor’s access with the duration of the underlying assets, requires expertise.  As advisors to our clients and disciplined allocators of their capital, we must build portfolios to weather all types of market cycles. 

Regardless of the fund structure, the role of hedge funds in a portfolio is important, and we will continue to give our clients this exposure.  The key is finding the right manager and structure, whether a private partnership or a mutual fund – a challenge that demands ongoing research and evaluation, and the discipline to not simply jump on the latest investment bandwagon.