Understanding Liquid Alternatives: Ask The Right Questions

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Includes: COGIX
by: Brian Haskin

Financial advisors and other professional investors often have a lot of questions about liquid alternatives, and for good reason. The investment strategies used in alternative mutual funds and ETFs are not straightforward by any means. Many use some form of leverage. Most utilize the ability to short securities, while others use a variety of derivative instruments to efficiently gain exposure to certain assets classes or securities.

But when used properly, liquid alternatives can be an effective tool to mitigate risk, increase diversification and/or enhance returns. So what questions should advisors be asking? To answer that question, Cognios Capital, managers of the Cognios Market Neutral Large Cap Fund (MUTF:COGIX), has produced a handy guide, "FAQ: Liquid Alternatives." The eight-page white paper answers the following frequently asked questions:

  1. What is the difference between traditional alternative investments and liquid alternatives?
  2. What is the benefit of adding alternatives to my portfolio?
  3. How many different alternative strategies do I need?
  4. From where should I fund my alternative allocation?
  5. Are there risks that are unique to alternatives?
  6. Why not just invest in a multi-strategy fund?
  7. Why is there such a large difference in returns among the different types of alternative strategies?
  8. What does it mean to be Beta Neutral?
  9. How are fees and expenses reported for alternative mutual funds?

Cognios's white paper answers each of the above queries in great detail, devoting nearly a page to each answer. What follows is an abbreviated summary of the report.

Traditional Vs. Liquid Alts

Alternative investments include assets such as commodities, currencies, and private equity; as well as public-equity strategies such as long/short equity, market neutral, and equity arbitrage. Traditional alternatives are subject to less stringent regulation by the SEC, have less liquidity and transparency than liquid alts, and are open to wealthy individuals and institutions only. Liquid alts offer similar exposures but through SEC-regulated mutual funds and ETFs, with daily liquidity and greater transparency.

Benefits of Allocating to Alts

Alternatives present many potential benefits, but perhaps the most obvious is their potential to improve the risk-adjusted return of portfolios through exposure to assets and strategies with low correlation to traditional stocks and bonds.

How Many Alts are Needed?

According to Cognios, a 10% to 25% allocation "may be an optimal range" for individual investors. As for the optimal number of different alternative strategies, this depends on investors' desired outcomes. Alternatives aren't a single "asset class" - a variety of strategies pursue a variety of different outcomes.

Funding an Alts Allocation

Should alternatives be funded from the equity portion of a portfolio, the fixed-income sleeve, or a separate "alts" sleeve? According to Cognios, there is no one right time to add alts to a portfolio - and similarly, there is no one right way to fund them.

Unique Risks

Cognios cites the following as unique risks to investing in alts:

  • Insufficient manager experience
  • Limited track records
  • Difficult-to-understand strategies

Multi-Strategy Funds

Investing in a multi-strategy fund leaves the decision of which strategies to invest in and how much to allocate to each strategy up to an outside manager. While this can be beneficial, multi-strategy funds sacrifice customization for ease. Furthermore, multi-strategy funds aren't always fully diversified within the alts space, so certain single strategy funds may be needed to complement multi-strategy holdings.

Dispersion of Returns

Since alts aren't a single "asset class," it makes sense that there would be a wide dispersion of returns across the different alternative assets and strategies. But even within a given strategy, wide dispersion between the best and worst performers is common, since many funds operate different sub-strategies and most are unconstrained by benchmarks.

Beta Neutrality

A "beta" of 1.0 indicates 100% correlation with a given benchmark. Equity market neutral funds pursue "beta neutrality," meaning a beta of as close to 0.0 as possible. This way, their returns are isolated from the fluctuations of the broad market.

Liquid Alts Fees

While alternative mutual funds certainly have lower fees than their hedge-fund counterparts (in most cases, at least), their fees aren't necessarily as straightforward as those of traditional mutual funds. This is because strategies that engage in short-selling incur related costs, whereas traditional mutual funds don't sell short, and thus don't incur these added charges.

Download the full guide for complete answers to the nine questions (linked above).

Jason Seagraves contributed to this article.