Madoff's Revenge: The Rise Of Liquid Alternatives

Includes: DLR, HCP, TYG
by: O'Brien Greene & Co.


The fast-growing new asset class "Liquid Alternatives", which market hedge fund strategies to small individual investors, often have excessive fees and lack transparency and liquidity.

The rise of "Liquid Alts" is the result of failed regulation that expanded access to risky, expensive hedge funds rather than reigning them in after the Madoff scandal.

With their high fees, "Liquid Alts" are a bonanza for unscrupulous advisors who have fee-sharing arrangements that are common among broker-dealers and 401k managers.

The biggest new theme at investment advisory industry conferences and in trade journals these days is the rise of "Liquid Alternative" funds. According to the sales pitch, virtually everyone is already using this new asset class, and anyone who is not will be left behind. Liquid Alternatives, however, are a complex and opaque investment that requires caution.

The name sounds more like some sort of dietary supplement than an investment product, but what exactly are they? Liquid Alternatives are a wide-ranging category of assets that are essentially funds that use a hedge fund strategy contained in a mutual fund wrapper. "Liquid Alts" include long/short funds, private equity, real estate, commodities and many other strategies and assets. More than traditional mutual funds, they tend to go short and use leverage and derivatives.

Assets in Liquid Alternatives increased 33% in 2013 to more than $244 billion according to research firm Strategic Insight. Proponents argue that they provide a great service by taking investment strategies that were previously reserved for the largest and most sophisticated investors and making them transparent, liquid and low-cost enough for individual investors. Also, their returns are not closely correlated to the stock market and therefore increase diversification and protect client assets in a crash, according to the story. Advisors now often add "Liquid Alts" to portfolios as an additional layer on top of a client's core investments, making up around 5-15% of assets.

In a recent Wall Street Journal column, however, Jason Zweig points out the troubling irony of the rise of this new category. After the Madoff scandal and the financial crisis, the Dodd-Frank reforms required hedge funds to register with the SEC for the first time. This was intended to reign in, the lightly regulated, high-risk funds. Once they were registered with the SEC, however, as Zweig explains, the funds became much more easily convertible to mutual funds. Whether this was the result of ineptitude of regulators or the meddling of lobbyists, the result was the opposite of what the regulation originally appeared to do. Massive failure and fraud in a hedge fund somehow ended up leading to the expansion of hedge funds to the broader, less sophisticated and more vulnerable audience of mutual fund investors.

But why would hedge funds want to give up their big fees for the smaller ones charged by mutual funds? The other factor driving the rise of Liquid Alternatives, Zweig says, is the relatively poor performance of hedge funds since the financial crisis that has made it harder to justify their usual 2 and 20 (2% of assets and 20% of return) fee structure. Now hedge funds are willing to settle for the more modest mutual fund fee around 1.5%. Again, this is highly ironic. A $50 billion Ponzi scheme and then a period of poor performance have set the stage for a huge expansion of the hedge fund industry into the mainstream.

Even with lower fees the rise of Liquid Alternatives is a potential windfall for hedge funds as it opens up a vast new market. But it also came at a convenient time for advisors. The financial crisis cast doubt on the effectiveness of the usual means of diversification. The typical 60-40 stock and bond portfolio was hit hard in the crash. Now with both stocks and bonds looking fairly expensive and interest rates on the rise, advisors are looking for an alternative that could hold its value in a crash and soothe skittish investors. This is where Liquid Alternatives come in. They are marketed as "uncorrelated" assets that increase diversification or act as "insurance" or a "shock absorber."

But there are a number of reasons why investors shouldn't drink the Liquid Alternative Kool-Aid. First of all correlation should never be the only criterion of an investment. To say that a fund increases diversification is not a sufficient reason to invest. You have to evaluate the investment on its own fundamentals, not just its correlation with the market. In 2013 for example, portfolios that made big, poorly timed allocations to emerging markets, gold, or other commodities in the name of diversification did not turn out so well.

A closer look at Liquid Alternatives also reveals that they are not as transparent or as low cost as the mutual fund structure might imply. While they are more accessible than their upmarket hedge fund counterparts, they still lack transparency and have higher than average fees. Earlier this year we came across a large position in a Liquid Alternative type fund in a prospective client's portfolio called the Dunham Monthly Distribution fund. The complex "merger arbitrage" fund had an expense ratio above 3% and an up-front "load fee" of more than 5%. These huge fees dwarfed the investor's return. The attraction of the fund was that it held up fairly well in the market crash and was not linked to the return of the S&P 500. However, with the enormous fees and low returns, simply holding cash would have been better for the client.

Another Liquid Alternative fund I came across was the Wells Fargo Advantage Absolute fund that is managed by the well-regarded firm GMO. This wide-ranging "absolute return" fund looks for returns in whatever asset class its managers deem attractive, and the fund has an excellent track record before subtracting fees. Looking at its prospectus, however, it is extremely hard to figure out what exactly the fund owns. It is pricey with a fee of 1.69% of assets, and there is a hefty 5.75% load fee paid up front. That means you begin your investment substantially in the hole. Moreover, the funds' Morningstar page suggests it has a substantial position in cash, so despite the big fees, much of the investment remains on the sidelines.

This lack of transparency highlights another problem with advisors jumping into Liquid Alternatives: they are usually highly complicated investment strategies that the advisor may not be qualified to evaluate. I am skeptical that advisors who spent most of their career with stocks and bonds and traditional mutual funds are able to pick the best private equity or managed futures fund. Even the most diligent advisor will probably not grasp the details of such opaque and specialized funds. Not being able to look directly at the holdings or understand the strategy means you put a lot of blind faith in the manager of the fund, and this adds a substantial risk.

So how do the advisors choose from these complex strategies? Too often, I suspect, advisors are choosing the ones that give them the biggest cut of the hefty fees that Liquid Alternatives charge. Liquid Alternatives are a potential bonanza for unscrupulous advisors who have fee-sharing arrangements that are common among broker-dealers and 401k managers.

Finally, Liquid Alternatives are a potential boondoggle because there is little accountability. Funds that have a low correlation and therefore are not supposed to keep up with the market have no reliable benchmark. The only way to evaluate them is to see how they held up in a crash, but not all crashes are the same. Some stocks that weathered the 2000 bursting of the internet bubble got crushed in the 2008 financial crisis for instance.

So for some advisors, Liquid Alternatives are very attractive. They are a high-fee investment vehicle that are difficult for clients to understand but do not need to produce reliable returns. This can be a perfect arrangement for self-interested advisors but not so much for clients.

So what is our strategy? We have not jumped on the Liquid Alternative bandwagon, and prefer to invest in individual stocks and bonds because we think it's important to keep fees low and know what you own. We have, however, invested in a number of alternative types of securities that can achieve a similar outcome as Liquid Alternatives but without the expense and complexity. One is example is Real Estate Investment Trusts or REITs. REITs have been around for more than 50 years and trade like stocks but are a good way to invest in real estate. Some examples of REITs we like include data storage company Digital Realty Trust (NYSE:DLR) and health care REIT HCP (NYSE:HCP). Another example of a non-conventional asset type is the Tortoise Energy Infrastructure fund (NYSE:TYG) of Master Limited Partnerships(MLPs). This fund of MLPs that are pipelines that carry natural gas and oil. It is an alternative type of asset that gives us access to investment in the US energy boom without the complexity and fees of hedge fund strategies. We've been following the fund for many years and have met personally with management.

We are willing to consider different types up assets to increase diversification, but so far the Liquid Alternative movement does not live up to its billing as sufficiently transparent, liquid or low-cost.

It seems despite his being locked away in prison Bernie Madoff's legacy is still stirring up trouble in the financial world. This is perhaps one of the most troubling results of the recent financial crises: we have not learned our lesson. Our responses to the crises (mostly the Dodd-Frank reforms) seem to reinforce many of the causes. The rise of Liquid Alternatives is good for some advisors and fund companies but will likely result in individual investors holding funds that are unsuitably expensive and risky.

Disclosure: The author is long DLR, HCP, TYG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.