Alternative mutual funds, also known as liquid alts because they can be traded at their net asset value, are the hottest fund category since 2013. Growth rates of liquid alts have trampled traditional equity funds and embarrassed yesterday’s hot commodity funds. Liquid alts are the hottest asset class around, but will a closer look cool their appeal?
The first rule of liquid alts is that you are not buying an asset class. You are buying the brain of a fund manager. Managers have broad latitude to follow a number of hedge fund strategies, including things like long-short and other relative value trades meant to capitalize on temporary mispricing. The common feature among alts is that they are not simply a long fund. They don’t just buy and hold a single category of assets.
Asset class investing is more straightforward. An advisor can assess the value of a manager relative to a benchmark within an asset class. The fund manager has the ability to execute limited long strategies within the asset class, which primarily consists of identifying which equities within that class to buy and sell. Alt fund strategies provide much greater flexibility for a fund manager.
Flexibility means that the fund manager better know what he or she is doing. Are advisors selecting alt funds for a client based on their ability to consistently capture excess return through the execution of strategic trades? Or are they simply attracted to a good story?
Generally, the liquid alt pitch goes something like this. Liquid alts are a new and unique type of asset class that doesn’t correlate with the rest of a long portfolio. Traditional long-only asset management strategies are so 20th century because they don’t use the new, modern hedge fund techniques that provide big returns for institutional investors. Why not slice off a bit of a client’s portfolio and invest it in a strategy that shows what a smart and innovative advisor you are?
There is some evidence that hedge funds can outperform traditional long-only portfolios, but the only factor that seems to provide this excess performance is illiquidity from hedge fund lock-up provisions. Liquid alts are essentially the hedge funds without the one factor that has been shown to provide excess returns.
I posed this question to Josh Charlson, director of manager research in the alternative strategies category at Morningstar. One advantage of liquid alts is that if they’re going to be sold as mutual funds, then they need to follow the rules of the 1940 Investment Companies Act (which is why they’re commonly called ’40 Act alternative funds). Traditional funds may charge investors a 2% fee on funds invested and a 20% performance fee. But ’40 Act funds can’t charge a performance fee.
Charlson notes that this creates a tradeoff in which the investor loses some liquidity premium but may gain in fees. “The strategies that are making their way into the mutual fund universe are the more liquid strategies,” notes Charlson. “There are a fair number of hedge funds that are not just taking advantage of the illiquidity premium that transfer to the mutual fund universe.”
A new article in the Journal of Banking & Finance, by professors Nic Schaub and Markus Schmid, provides evidence that the financial crisis erased the illiquid funds advantage over funds that allowed easier investor exit. While illiquid hedge funds outperformed between 1994 and June 2007, they got crushed during the financial crisis. Add in the financial crisis and there was no illiquidity premium.
Charlson notes that another potential benefit of housing hedge fund strategies within the ’40 Act regulatory umbrella is increased disclosure: “You’re gaining transparency in terms of the portfolios and you no longer have the illiquidity disadvantage from limited redemption.” Indeed, for those who value alternatives for their low correlation with traditional assets, the poor performance of illiquid funds during the financial crisis coupled with the inability to pull money out of their accounts makes illiquid alts less appealing.
Alts as Asset Class
This is probably the biggest misunderstanding about alternative investments. I often get the impression from reading stories about liquid alts in the financial media that managers are selecting magic fairy dust assets that provide much sexier returns than boring traditional stocks and bonds. Unfortunately, the actual investments are often simply derivatives of the boring asset classes minus transaction costs.