It pays to take an in-depth look at liquid-alt strategies.

Liquid alternative investments have tripled in the past few years, growing from about $102 billion in early-2011 to $314 billion as of Sept. 30, 2014, according to recent Aite Group report.

But despite the increasing popularity of liquid alts, there are several misconceptions about funds that focus on these investments,  say Aite analysts Howard Tai and Gabriel Wang in their study “Liquid Alternative Investments: A Passing Fancy, or the Real McCoy?”

The study examines these notions in detail and debunks some common myths about liquid-alt funds, including those that claim:

  • Investors’ “hot money” chases fund performance
  • Large fund size with a more prestigious manager ensures better performance
  • Funds with the highest returns provide the best risk-adjusted results for investors.

Hot Money

Hot money chases hot performance—or does it?

The Aite research considered fund flows through the third quarter of this year and found very little evidence to support the cause-and-effect theory that good performance will lead to significant inflows for hot funds and their associated investment strategy.

For example, market-neutral funds, which produced slightly negative year-to-date returns, attracted the most money as a percentage of assets under management. In contrast, dedicated short-bias funds had asset growth of 5%, even though they posted the worst five-year performance of the strategies reviewed by the consulting group.

“Maybe in the initial year or two, or even three, performance tends to be the deciding factor in attracting flows, but that’s not always the case,” says Tai. “There are some really good performers that don’t get the right level of publicity and marketing support or distribution, and then they become sort of the best kept secret in an industry.”

A more likely explanation for inflow growth among funds that became the biggest in their respective categories is that increased marketing support and broader distribution networks help these big funds attract new money, he adds.

Fund Size

The largest fund sponsors, as measured by assets under management, have the resources to hire the best analysts and managers, so in theory they should outperform their less well-funded competitors.

The research doesn’t support that belief, however, and several of the 10-largest funds underperformed their smaller category-peers during the first three quarters of 2014.

Having a significant level of assets can reduce a fund’s investment options and flexibility, Tai explains.

If a fund’s size gets too large, managers can experience problems deploying new cash into the strategy or when reducing exposure to specific securities within that strategy. Those types of liquidity challenges can make it difficult to sustain good performance, he says.

Risk-Adjusted Returns

An investor’s goals matter in fund selection, Tai explains. Some strategies are better suited for risk reduction; they’re not intended to produce outsized returns.

In addition, as with other asset classes, there is no free lunch with liquid alts: The tenet that earning a higher return requires taking on additional risk still holds true. The study concludes that the best -performing funds tend to have the most volatile returns.

“If you just go for the fund with the best return, it most likely will have the highest price volatility — you get what you pay for,” the expert states. “You buy something that may one day give you a better return, but the next day it may not.”