This is the latest 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.

I get a lot of questions about liquid alternative funds, which are quickly becoming go-to investments for advisors looking for diversification. Many of these inquiries involve the portfolio constituents for such vehicles, and how liquid they would be in a volatile market environment such as the global financial crisis in 2008. 

These concerns increased after Chuck Jaffe wrote ‘Is your ‘Alternative’ Fund a Ticking Time Bomb?’ on MarketWatch. The article raises a number of issues that need to be addressed. 

  • The claim that the term liquid alternatives “typically means buying illiquid securities—things like private credits and some derivative issues—and turning them into a fund that is “liquid” because it can be bought or sold at any moment on the open market,” as quoted in the article—is unfounded. Liquid alternative strategies are designed to have market betas less than that of traditional funds, and their objectives can often be met by trading entirely liquid securities in nontraditional combinations.  
  • Liquid alternative funds have to comply with the same liquidity rules as all mutual funds. SEC rules allow 40-Act Funds to have 15% illiquid investments (those that cannot be sold within seven days). 
  • Illiquid securities are much more prevalent among traditional bond funds. Esoteric corporate credits litter many aggressive fixed income funds, which have become very popular in this yield-hungry environment. 

    The lack of current prices gives these funds “flexibility” in how they mark illiquid positions for month-end reporting, and can artificially reduce estimates of volatility and correlation. Fortunately, there are ways to measure this effect and thus identify which mutual fund returns are more risky than they appear.

  • “Why would a mutual fund buy an illiquid security in the first place?” is a reasonable question. The answer is simple: because it increases performance. Better returns result in more assets, and thus more fees.

Liquidity should be thought of as another risk factor. Have you ever noticed that equal-weighted indexes outpace their cap-weighted cousins? Part of the reason is that the former are more risky from a liquidity standpoint than the latter, as smaller stocks make up a bigger portion of the portfolio.

Taking that additional risk may be solid in a bull market, but could result in underperformance during a downturn.   

See the complete series of blogs, Ben Warwick on Liquid Alts.