Risk Management Considerations For Alternative Mutual Funds (40 Act / Liquid Alternatives)
Seeking Alpha Analyst Since 2014
Alternative Investments industry is going through a transformation in market structure, with a new trend developing in the "liquid alternatives" space. Quoting SEI1, alternatives are migrating from institutional to retail markets, just as the use of asset allocation models did several decades back. Every industry conference/seminar includes a discussion on liquid alternatives, registered alternative funds or UCITS and 40 Act funds.
This blog gives basic preview of the drivers for the focus on liquid alternatives, and key risk management considerations for managers and investors of liquid alternatives.
The Focus on Liquid Alternatives
The recent popularity of the product is driven on the one hand by alternative asset managers looking to access retail distribution channels following difficult institutional fundraising environment. And on the other hand, increasing interest from three demand circles; direct retail, 401k and institutional investors.
- Direct retail investors: Aging population looking to retire over the next decade has a preference for lower risk strategies
- Indirect retail via 401k/defined contribution plans: Plan administrators are increasingly evaluating an alternative mutual fund offering as a plan option next to long-only strategies
- Institutional investors: Investors initiating or increasing allocation to alternatives would like to maintain liquidity option while still investing in alternatives
The demand circles are in some ways influenced by 2008 financial crisis. Following steep losses from long-only strategies during the crisis and delayed liquidity from alternative strategies in form of term extension, gates and side pockets, investors are increasingly looking for products that offer downside risk mitigation, but with better liquidity characteristics.
The chart above shows return distribution of S&P500 vs. HFRI Equity Hedge Index ("Equity L/S") from 1990-2013. Equity L/S is up 70% of the months, while S&P 500 is up 67% of the months, however it also has months with large gains and large losses, resulting in fatter tails. Although Equity L/S strategy does not participate in extreme upside, it also provides relative drawdown mitigation.
This results in key difference in cumulative return profile. Equity L/S strategy shows annualized return of ~13% with a standard deviation of 9%, while S&P 500 shows annualized return of ~9% with a standard deviation of 15%. There are obvious weaknesses with this analysis, such as (a) HFRI Index is not investable, and to arrive at the index return, one needs several investments with varying risk profiles within a strategy group, which most investors do not have the capacity and in-house expertise to achieve, (b) HFRI index has survivorship bias, as the underperformers or funds that liquidate cease to report performance over time.
In spite of the above drawbacks, the Equity L/S strategy has a materially better risk-adjusted sharpe ratio relative to S&P500. The ability to short in the universe of long/short strategies continue to be attractive, especially as investors face the risks associated with macro growth concerns, bond market sell-off and equity market valuations.
Risk Management Considerations for Managers and Investors
FOR MANAGERS: Key risk management considerations as they adapt their business models to match structural, investment, operational and regulatory aspects of registered liquid alternative strategies:
- Focus on Due-diligence and Conflicts
Perform in-depth due-diligence in partnering with custodians, administrators, board of directors, and distribution channels as daily NAV reporting, multiple investor management, multi-asset reporting and compliance with leverage, shorting and liquidity requirements require heightened attention in these newer structures.
- Ensure Liquidity Alignment
Ensure match between asset liquidity and investor liquidity, both in current and particularly in stressed markets. Liquidity is a dominant success factor associated with these structures, especially for retail markets, and hence subject to substantial headline risk. Ensure strategy and asset class fit, optimal cash buffer and devise decision tools to adjust these as the macro factors affecting asset liquidity change over time.
- Strengthen Investor Disclosure and Education
Disclose the risks of investments as well as the risk of divergence in performance relative to the private alternatives. Given the liquidity requirements for liquid alternatives, the strategy will seldom be a replica of the parallel private structures. Only the most liquid hedge fund strategies such as global macro, equity long/short and to some extent relatively liquid event driven and relative value strategies are a fit for these structures, and may still result in return differentials.
Examples that would drive the difference in returns even for the most liquid strategies: For a thematic macro strategies, where a manager is betting on a theme that develops over three to six months. Similarly, a typical merger arbitrage strategy takes few months to mature from the announcement of a deal, followed by regulatory, and shareholder approvals. Given the daily investor liquidity for the most liquid structure, the manager may limit allocation of risk to strategies that require longer holding period.
As managers adjust their risk allocation and holding period to match the daily investor liquidity required by these products, the portfolio composition will change and the return component associated with the liquidity premium will decline. Cliffwater2 recently published a study on the performance differential between private vs. liquid alternative, and found that the returns for liquid alternatives on average trail private alternatives by approximately 1% annually. However, it is worthwhile to note that this study also includes managed account structures which could include less liquid assets which have significantly higher liquidity premium.
FOR INVESTORS: Key risk management considerations as they evaluate registered liquid alternative strategies:
- Understand Structural Risks
Understand the structure, and the investor liquidity offered for each of the various forms of liquid alternatives and the fit of these products in your overall portfolio allocation. Chart below shows a basic framework of open ended and close end liquid alternatives. Typically, open ended strategies are more suitable for hedge funds and closed end for private equity investments.
Refer to Citi's Primer3 as a reference that has in-depth explanation of each structure.
- Review Strategy and Liquidity
Ensure alignment of liquidity characteristics of the underlying assets and strategy to the liquidity offered to you as an investor. Avoid risks of investing in strategies which offer high investor liquidity, but may pose the risk of material NAV discounts in stressed markets.
- Evaluate Business Risks
There have been numerous launches of liquid alternative products, but with small asset sizes. Liquid alternative structures require increased investment in operational, reporting and compliance infrastructure and hence investors must consider break-even asset size when assessing business risk. Additionally, investors should pay close attention to conflicts of interests and partnership arrangements as there are more parties involved in the structure. For example, often the investment managers and sub advisors may not be the same in the structure, and any friction or conflict in this relationship could negatively affect the performance of the overall product.
- Manage Return Expectations
Adequacy of returns could potentially be the biggest source of disappointment for the retail investors when benchmarking liquid alternative returns with the headline returns associated with broader private hedge fund indices. For reasons highlighted in #3 under risk management considerations for managers, there may be divergence in performance. A better benchmarking for liquid alternative products would be comparing risk adjusted return or sharpe ratio with long-only products.
The above list highlights risks distinct to liquid alternative structures from both manager and investor's perspective. This is not a comprehensive list of risks, nor is a substitute for risk, legal, and compliance professional advice or services.
Additional Resources on the Topic
1: SEI: The Retail Alternatives Phenomenon
2: Cliffwater Research: Performance of Private versus Liquid Alternatives: How Big a Difference?
3: Citi Prime Finance Primer: Introduction and Overview of 40 Act Liquid Alternatives Fund