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Liquid Alternatives: A Quick Coming of Age

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Score one for the individual investor—and his or her advisor. In an unusual twist, the smart money appears to be following the small retail investor into alternative mutual funds, also called “liquid alternatives.” After striking a chord with retail investors, liquid alternatives are attracting institutional money in a big way. In almost every strategy, from emerging markets to bond portfolios that can go long and short, an increasing percentage of institutional investors say mutual funds are their preferred way to access alternatives, according to a year-to-year comparison conducted by Morningstar and Barron’s.

Long before Fed Chair Janet Yellen expressed concern in July about “stretched” asset values, investors were looking for diversification and downside protection in case the bond and stock markets were to turn bearish. However, her comments about possible bubbles put the search for diversification into sharper focus.

Why are institutions allocating assets to these “hedge fund lites,” as they are also sometimes called? Why not stick with traditional hedge funds, the go-anywhere mavericks that are free to use leverage or hold illiquid stocks?

Brian Haskin, founder of DailyAlts, a website that provides information about liquid alternatives, says one reason is that some big hedge fund managers are willing to offer their talents to alternative mutual funds. Leon Cooperman of Omega Advisors, one of the titans of the hedge fund industry, recently agreed to sub-advise a long-short equity mutual fund. Can George Soros be far behind?

Plus, institutional investors are highly sensitive to fees. “With the migration of some of these renowned hedge fund managers to liquid alts, institutional investors are asking themselves why they should pay 2-and-20 for the same performance expectations,” as Haskin told a colleague. “It’s almost a no-brainer.”

Citing a 2013 study, “Performance of Private Versus Liquid Alternatives: How Big a Difference,” conducted by Cliffwater LLC, Haskin says restrictions on leverage and liquidity means alternative mutual funds on average will underperform their purebred hedge fund cousins. Daily liquidity results in alternative mutual funds’ performance trailing traditional hedge funds by an average of 1% annually. Investors apparently think that is a small price to pay.

By this summer, assets in alternative mutual funds totaled about $300 billion. That’s a small percentage of the $17.1 trillion in total mutual fund assets, but it’s the recent rush of money into alternative mutual funds that’s impressive. Nearly a third of total alternative mutual fund assets, or $95 billion, arrived in 2013. Not only was that five times more than in 2012, but it accounted for 32.4% of the inflows for the entire mutual fund industry, according to an analysis of Morningstar Direct open-end mutual fund data conducted by SEC staff.

This rush of money into alternative mutual funds is remarkable, given that “alternatives” are still a mystery to many investors. Clearly, the soaring demand for diversification and low correlation, the efforts of registered investment advisors and the fact that alternative mutual funds are free to advertise have combined to create a powerful marketing message.

It could be a win-win all around. For hedge fund managers, the U.S. market for publicly traded funds “may be one of the largest remaining untapped pools of assets available for hedge fund managers to consider globally, as a report published in 2013 by Citi put it.

As this young industry evolves, it bears watching which investment strategies work best in alternative mutual funds. Distressed debt, for example, is unlikely to be successful because the underlying securities are illiquid. Long-short equities, on the other hand, are ideal, and these continue to attract the most assets into alternative mutual funds. In 2013, assets under management in these funds increased a staggering 80%, according to Morningstar and Barron’s.

I’d be remiss if there was no mention of the risks, both perceived and real. Alternatives may not be suitable for everyone and there is no guarantee that any strategy will achieve its objective, generate profits or avoid losses. From where I sit, liquid alternatives are about to become as familiar a presence in portfolios as traditional stocks, bonds and cash.