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?

The 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.

Since most liquid alts were created after the financial crisis, there isn’t much of a track record of performance during a bear market. Charlson notes that “it’s been a pretty anomalous period.” While equity funds have flourished, the performance of alt funds has lagged. Total three-year returns in the liquid alt category have been about 2.9% compared to 10.8% in fixed income and 32.8% in equity funds. If you had pulled money from either stocks or bonds in order to fund the purchase of the average liquid alt, you’d have lost money.

One important difference between liquid alts and other mutual fund categories is the range of strategies that fund managers can use in order to generate returns. One might assume that because managers are not all investing in the same types of assets (or employing the same strategies), there will be a lot more variation in returns among liquid alts.

I asked Morningstar’s David Blanchett to calculate the standard deviation of returns among funds within seven broad mutual fund categories. This isn’t the standard deviation of returns within the alt category—it is the variation in return among each of the funds that call themselves a liquid alt. In other words, bond funds tend to all have returns that are similar over time. Liquid alts are all over the place.

Although their gross performance lagged equity funds over the last few years, alt funds may be capturing alpha, or market-risk-adjusted performance. However, the distribution of alphas among liquid alts is surprisingly left skewed with little evidence of the ability to achieve high positive alpha. In other words, more liquid alt managers generated extreme negative alpha than equity fund managers. But liquid alt managers didn’t gain it back on the positive side—a higher percentage of equity fund managers were able to generate three-year annualized alpha above 10%.

Manager Selection

The huge variation in performance and evidence of high negative alpha among some liquid alts means that selecting the right fund is far more important than in other mutual fund categories. An advisor also needs to understand the different styles employed by the various types of liquid alts. Both manager and strategy selection are a very inexact science, and research does not necessarily provide much guidance.

The most common hedge fund strategy is employed by the so-called long/short equity funds. The evidence on the success of long/short hedge funds is mixed at best. A 2011 article in the Journal of Empirical Finance, by prolific hedge fund researchers William Fung and David Hsieh, finds that a small minority (less than 20%) of long/short equity funds are able to achieve a measureable, persistent alpha. Of those that did manage to consistently generate alpha, the effect appeared to decay. And decaying alpha makes selecting the right hedge fund after the fact far more difficult.

What is a long/short strategy? Fung and Hsieh explain that a hedge fund that holds shares of stock can periodically earn an excess profit by lending shares to short sellers during periods of excess demand for shares to sell short. If managers can anticipate shares that will have strong short sale interest, or if they are lending shares during periods of high demand from short sellers, they can earn higher fees.

A fund manager employing a long/short strategy had better know what she’s doing. Many liquid alts are sponsored by hedge funds or private placement firms with experience executing hedge fund strategies. Mutual fund companies also are hiring hedge fund managers who may have worked for institutional clients. As one might imagine, a good manager doesn’t come cheap so expense ratios on liquid alts tend to be higher than mutual funds.

An advisor needs to select both a strategy, for example a long/short fund, and a fund manager. Some liquid alts use multiple manager or even multiple alternative strategies. How does an advisor choose the right liquid alt? First, look at the success of the strategy in the hedge fund world. If there’s evidence that it has consistently generated risk-adjusted returns for investors, then you can at least feel more confident in selecting a liquid alt using that strategy.

Due diligence is essential when deciding how to incorporate a liquid alt into a conventional portfolio. According to Charlson, “you don’t want to just go on the assumption that because it’s an alternative strategy it’s going to exhibit certain kinds of performance characteristics.” Each will have its own relative risk (beta) and historical correlations with the market. Even if a fund claims an objective of low correlation with the market, this may not always be the case—and a high correlation plus a lower net risk-adjusted return isn’t going to do much for a portfolio.

So how shiny are liquid alts in reality? It’s too soon to tell if these hedge fund strategies aimed at average investors are going to live up to the hype. Due diligence is the name of the game for any investment, but performing due diligence on a fund whose strategies are as complex and varied as a hedge fund isn’t an easy task. Everyone’s looking for a good story, but not all of them have a happy ending.