Will Liquid Alts’ Performance Sustain Future Asset Flows?

Aug 25 2014 | 10:34am ET

By Deirdre Brennan (The Alpha Pages) -- Forget questions about whether liquid alternative funds are here to stay. The surge of inflows to liquid alternative funds suggests that debate is over.

According to McKinsey & Company projections, inflows to liquid alternative funds will reach $900 billion by the end of 2015. That surge is likely coming at the expense of traditional hedge fund investments.

A study by Barclays Prime Services shows that capital flows into liquid alternatives—also known as hedge-like mutual funds—are outpacing dollars going into hedge funds. Liquid alternatives grew by 43% last year, while hedge fund assets increased by 15%.

Liquid alternatives are the fastest growing category of ’40 Act structures, even though they comprise a tiny part of the mutual fund industry. Recent data shows that the amount of capital controlled by alternative ’40 Act structures stands at $154 billion, which is just 1% of the entire mutual fund industry. In comparison, hedge funds control $2.7 trillion of capital.

The trend is picking up, particularly as conservative institutional investors like pension funds enjoy ’40 Act funds due to the lack of performance fees, reduced leverage, and beta-centric returns.

The alternative ’40 Act fund universe is in its infancy, with the most mature funds being no more than five years old. While industry watchers like McKinsey predict the industry will continue its exceptional growth, only time will tell if these vehicles can weather a storm.

Rather than debate the permanence of alternative funds, investors should instead ask a more important question:

Do increased liquidity and the lower fees provided by hedge-like mutual funds outweigh the lower expected returns?

Optimism remains high

The hedge fund versus alternative funds is a false debate thanks to industry advocates who are attempting to promote their products and services. They’ve said alternative funds don’t provide strong returns, aren’t managed properly, or that investor sentiment is dwindling.

But there is no shortage of optimism surrounding the launch of alternative ’40 Act funds.

“Clearly, this is the fastest growing category,” said Victor Viner, president of V2 Capital, which specializes in volatility-based equity derivative strategies. V2 Capital manages $500 million in a hedge fund vehicle, but is rolling that money over into a ’40 Act fund later this year.

“We are seeing more funds that can provide liquidity going into the liquid alternatives space for all of the obvious reasons from an investor perspective,” said Viner, adding that the main benefits of liquid alternatives include transparency, liquidity, and lower fees. But despite V2’s move into the liquid alternatives space, Viner warns that most hedge funds cannot be shoehorned into mutual fund structures.

“Not all, and not most, of traditional hedge fund strategies can exist in these structures. In our case, we’re lucky because everything we do and have done for four years falls well within the framework of what can be done in a ’40 Act fund,” said Viner.

The ’40 Act rules include limiting leverage to 33%, having less than 15% exposure to illiquid assets, and in most cases a prohibition on charging performance fees.

Adam Patti, CEO of IndexIQ, a pioneer in the liquid alternatives space, agrees that only certain strategies will work in a ’40 Act structure.

“The major hedge fund categories—long/short, market neutral, global macro— can [be] provided in a ‘40 Act fund fairly efficiently,” he said. “Strategies that require a significant amount of leverage won’t work. Strategies that tend to depend on illiquid, arcane asset classes won’t work.”

Instead of having a “one or the other philosophy” when comparing hedge funds and liquid alternatives, investors could see them as complementary products.

“The majority of our assets ($1.4 billion) are in a multi-advisory product that is basically the S&P 500 of the hedge fund market,” said Patti. “It is designed to give you the risk/return profile of a universe of a hedge fund of funds…. You would use that as a core product in your portfolio and then go out and find alpha-seeking hedge funds as satellites around it.”

A false sense of security?

One of key selling points of liquid alternatives is transparency.

But while transparency may seem like an obvious benefit, Bill McBride, executive vice president at quantitative research and technology specialist Markov Processes International (MPI), wonders whether having access to the underlying investments does any good.

“The Securities and Exchange Commission (SEC) says investment advisers are fiduciaries and need to verify that a fund is executing its stated strategy based on available data,” explained McBride. “How many advisers can internally price and net the exposures of the thousands of positions (including complex derivatives) in an unconstrained long/short bond fund?”

McBride added that technology to tackle the data issue is rapidly being developed.

“There is room to mature and we think it will happen quickly. Investors will seek advanced systems and analytical techniques to process liquid alternatives’ holdings data, net exposures and grasp a fund’s strategy and potential risks, while managers will seek ways to enhance communication to investors, all potentially facilitated by SEC mandates as attention is increased on this rapidly growing space.”

Patti, who touts transparency, also thinks it is important for advisers and investors to “look under the hood” and get a better understanding of what is in each product.

“Advisers don’t know what they are getting and that’s a big problem,” said Patti, who believes educating advisers and investors should be a top priority for the industry as a whole.

Andrew Ross, associate director of Pacific Alternative Asset Management Company (PAAMCO), which has approximately $9 billion in discretionary assets under management, points out that transparency is not unique to the ‘40 Act fund structure.

“Institutional investors can receive transparency and independent oversight of their hedge fund investments in their traditional private placement hedge fund investments,” said Ross. “Some institutional investors are already receiving all of their positions on a monthly basis with a less than 30-day lag, which is far superior to the required 60-day lagged, quarterly transparency of liquid alternatives.”

Of course both pale in comparison the managed futures, which offers daily transparency in the typical managed account structure.

PAAMCO, specializes in fund of hedge fund structures and caters almost exclusively to institutional investors, and has no plans to enter the ’40 Act space.

“At this point we do not feel that this product is appropriate for institutional investors and we do not have a view on its suitability for retail investors,” said Ross.

Liquidity and systemic risks loom

While liquidity is usually touted as a benefit for investors, McBride feels that just like transparency, investors may be relying too much on the idea of it rather than the reality.

“How can you have daily liquidity in a $4 billion equity long-short fund?” McBride asked. “The senior hedge fund managers I have spoken with have expressed serious concern that large liquid alternatives vehicles could have trouble raising cash very quickly if executing a truly hedge fund like strategy.”

The SEC is also voicing its concern. The regulatory agency has already begun investigating 25 liquid alternative funds on structural matters of leverage and daily liquidity and the associated risks. PAAMCO’s Ross also believes that promises of daily liquidity are overstated.

“The daily liquidity of liquid alts can create ‘bank-run’ risks because of the asset-liability mismatch problem created. Although liquid alternative funds have stated daily liquidity, current rules actually allow these funds to operate without the ability to liquidate all underlying investments in a day,” explained Ross. “Although ‘bank-run’ risk exists in all mutual fund structures because the investors in them have daily liquidity, the risk is heightened with liquid alts due to the relative novelty of the strategy to the retail investor.”

The regulatory efforts aren’t likely to end just on concerns about liquidity. In fact, liquidity fears will likely generate expanded efforts by agencies to dig deeper into how these funds generate returns, their risk management strategies and their marketing practices.

Liquidity penalties on performance

Despite concerns about increased regulation in the space, liquid alternative funds provide one big benefit that isn’t going unnoticed. Lower fees.

The question investors must ask is: Will the lower fees be enough to offset the difference in performance?

One recent study by advisory firm Cliffwater found a 1% drag on performance for hedge funds going into ‘40 Act structures. But that isn’t shaking faith in these funds.

“Call it the liquidity penalty,” said Viner, who despite the potential lag in performance believes the lower fees will more than offset gains that can be made in a hedge fund vehicle.

“A lot of managers are highly correlated to the S&P and they are producing beta, but they are charging 2% management fee and 20% on profits,” said Viner.

Over time, one can expect that alternative funds and their hedge fund cousins will be debating the merits of their structures and ultimately their performance. For now, the jury remains out. As for solid, historical evidence on the long-term returns of hedge funds versus those of liquid alternatives, there isn’t any.

As the industry takes shape, time will tell which side is able to earn the bulk of new asset flows. For now, it’s up to investors and the media to do the diligence.

This article first appeared in The Alpha Pages.


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