A Better Alternative? Liquid Alternative Funds Give Investors New Options

by: Reality Shares Research
Summary

The 2008 financial crisis marked a turning point in the perception of alternative investments and brought about explosive growth in a new asset class broadly characterized as “Liquid Alternatives".

In the aftermath of the crisis, investors suddenly demanded with more fervor alternative investments that were liquid, but could also provide the benefits of diversification through non-correlated investments.

The rise of Liquid Alternative mutual funds and ETFs are democratizing some of the strategies pursued by the largest and most sophisticated institutional investors.

By Naim Abdullah, Assistant Portfolio Manager, Reality Shares, Inc.

The 2008 financial crisis marked a turning point in the perception of alternative investments and brought about explosive growth in a new asset class that is broadly characterized as "Liquid Alternatives." The S&P Total Return Index crashed 57% from its peak and investors fled traditional investment funds. However, since traditional alternative funds were structured as limited partnerships, an investor's capital could be locked up, and many alternative funds restricted redemptions.

This has been the way things worked for a long time. High returns in uncorrelated asset vehicles (mainly hedge funds) used to come with strings attached - including illiquidity. However, in the aftermath of the crisis, investors suddenly demanded with more fervor alternative investments that were liquid, but could also provide the benefits of diversification through non-correlated investments. Simply described, liquid alternatives provide access to alternative investment strategies via more traditional structures such as mutual funds or exchange-traded funds (ETFs).

Growth of Liquid Alts

Over the course of the past seven years, assets under management (AUM) in Liquid Alternatives have grown from around $30 billion in 2008 to a projected $300 billion in 2015. ETFs make up only a small fraction of that total, roughly $2 billion, but are growing rapidly due to the soaring popularity of ETFs and an ever-increasing variety of ETF-based liquid alternative strategies. But while 30% of institutional investors' AUM is invested in alternative vehicles, it is estimated that retail investors allocate only 2% on average. However, Goldman Sachs research analysts forecast that retail liquid alternatives are in the "early stages of a 5-10 year growth trend" and expect 15-20% growth annually - similar to the early stages of ETF growth.

Defining Liquid Alts

Alternatives is a term intended to capture a broad group of asset classes and investment strategies that offer a return stream that differs substantially from traditional stocks and bonds. Investors hope that by including an allocation to alternatives, their portfolios will benefit from lower risk and higher returns through varying market conditions compared to what they would otherwise have experienced from a traditional stock/bond-only portfolio. Liquid Alternatives are a subset of Alternatives that offer daily liquidity through an open- or closed-end '40 Act mutual fund or ETF.

Liquid alternative ETFs broaden the opportunity set for investors who seek to diversify their exposure. They deliver access to markets that were once simply unavailable to most investors. They do so with greater transparency and at a lower cost compared to traditional hedge fund vehicles.

The main benefits liquid alternatives seek to provide investors are assets returns with low market correlation, reduced portfolio volatility, and superior risk adjusted returns.

Pitfalls in Investing in Liquid Alts

Alternative investments offer strong diversification potential, lowering risk measurably without sacrificing return. However, selecting from the broad range of alternatives can be a challenge, even for the experienced investor.

While alternative investment strategies provide uncorrelated returns streams that can dampen portfolio volatility and boost risk adjusted returns, many of these strategies do not fit well in a '40 Act structure. The major alternative strategy categories that tend to require a significant amount of leverage to produce their targeted returns simply won't work as effectively. Under the '40 Act law, mutual funds and other open-ended investment vehicles are limited in their use of leverage and as a result their returns suffer. In addition, strategies that tend to depend on illiquid, arcane asset classes tend to struggle. Alternative mutual funds and ETFs must give investors daily access to their funds. To facilitate the ability to redeem withdrawals in these funds, which are often backed by illiquid securities, alternatives generally invest a portion of their funds in cash, producing a drag on returns.

In addition, while both mutual funds and ETFs with alternative assets are substantially less expensive than the typical 2% of assets and 20% of gains that hedge funds charge in fees, ETFs hold an advantage in this area over mutual funds. Alternative mutual funds charge average fees of 1.62%, which is substantially higher than the fees and expenses for a typical ETF or mutual fund. Liquid Alternative ETF fees are less expensive on average than their mutual fund counterparts, with fees ranging from 0.48% to 1.5% and an average fee of 0.89%, but are also more expensive than basic index fund ETFs.

Conclusion

The rise of Liquid Alternative mutual funds and ETFs are democratizing some of the strategies pursued by the largest and most sophisticated institutional investors. They offer an opportunity for enhanced returns and lower correlation to the stock and bond markets, which may be especially beneficial in times when markets are at an inflection point or lack clear direction. And they do so while offering more attractive costs and liquidity. While there are pitfalls to avoid, and it is important to thoroughly research the funds' underlying strategies and risks, Liquid Alternatives offer an exciting new investment opportunity for a wide range of investors.

Business Relationship Disclosure: This article was written by Reality Shares, Inc. Research Team. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

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