Investors Welcome Second Wave Of Liquid Alternatives

Sep 2 2014 | 9:15am ET

By Mary Campbell
Senior Reporter, FINalternatives

It seems like only yesterday that the first wave of liquid alternative funds washed over the financial industry, and yet those in the know are already talking about a second wave—if not a third.

Morningstar pegs the liquid alternatives universe today at 455 funds managing $154 billion—up from 217 funds managing $38 billion in 2008.

The category has been validated by these numbers, according to John Culbertson, CIO of Context Asset Management, which manages a family of liquid alternative funds. And as liquid alts. assets under management have waxed, money manager skepticism has waned:

John CulbertsonJohn Culbertson“We've spoken to approximately 75-100 hedge fund managers,” said Culbertson. “Everybody from $50 billion in AUM and down, and when we first started this a year and a half or so ago...we felt that there were a lot of skeptics. There are no longer skeptics. There are...managers who might make a decision not to be involved in the business, but it's not because they don't think there are assets available here.”

Culbertson said this is bringing better and higher-quality managers to the table, ushering in what he sees as the second wave of liquid alternative funds.

Liquid Alternatives 1.0

But before discussing the second wave, it might be worth considering the first wave which, for Culbertson, was defined “largely by either selling access to large institutional managers—which is usually done by just marking fees up—or  with a product that is forced into a '40 Act wrapper that really doesn't allow the manager to do what they've done in the past due to  the '40 Act restrictions. The change in the underlying investment process is not good for the investor.”

The result, he said, has been “products that have either performed fairly well but with very high betas, or products with low betas and no performance.” Real, non-correlated alpha, he said, has been missing.

Aaron Izenstark of Northbrook, Ill.-based Iron Financial is blunter in his assessment of the problems with first wave funds—and he manages one.

Aaron IzenstarkAaron Izenstark“The first wave was a lot of hedge fund managers saying, 'Hey, the 1940 Act space has no clue so let's launch some funds in there and, yeah, we can't do the same strategy we did, because you can't use that kind of leverage in a 1940 Act but they'll have no clue.' That was the mentality,” Izenstark told FINalternatives.

He and Howard Nixon, former members of the Chicago Board of Trade, founded Iron Financial in 1994 and converted their credit opportunity strategy into a '40 Act mutual fund—the Iron Strategic Income Fund (IFUNX)—in 2006. The $430 million fund, which has produced a trailing total return of 7.5% over the past five years, generated a whopping 36% return in 2009 and is up 2.7% year to date as of July 31, according to Morningstar.

“You had a lot of strategies that weren't true liquid alt strategies that were calling themselves liquid alts as a marketing term...and that I think was the disappointment,” said Izenstark. “We see strategies that have dividend-paying stocks inside of their mutual fund and they call it a liquid alt.”

Iron Financial, he said, switched to a '40 Act wrapper only when it became feasible to do so:

“It really made no sense to put it into a mutual fund for the end investor until [2006] because there were not really enough liquid credit derivatives that would make sense for us to trade...,” he said. “The derivatives market started to become liquid enough on the credit side to allow for hedging of certain types of credit, and it just gave us more opportunities to do other things and we think it's one of those things that's actually a lot cheaper to run inside of a mutual fund...”

Another difficulty with first generation funds stemmed from what Culbertson terms “adverse selection:”
“Many of the managers to first enter the '40 Act world were managers that needed to do so to stay in business,” he said. “There was a reason why managers were willing to work for 1%, for example, and not for a performance fee—there's a broken track record, there's a succession issue...It wasn't the varsity, it was the JV. And that kept us out of the business for a while. We felt like until it was clear that the best managers were interested in managing money inside these structures...the whole trend would be called into question.”

And finally, said Culbertson, there was the issue of poorly managed expectations:

“Alternatives are not a panacea, they don't fix all portfolio ills. In certain environments they will not compete with risk betas, with risk assets...Expectations have been set so high that they're unrealistic...”

That's not the case today, he said:

“Expectations have been ratcheted back down, I think, and the next wave of product will look a little different.”

Liquid Alts 2.0

In addition to better managers, Culbertson thinks that difference will include more rational pricing:

“In the managed futures space, for example, many of these products are really just alternative beta, they're not truly alpha, and they're priced at very premium alpha product levels—you have a 1.5% and 20% structure hiding behind an offshore blocker that then is put into a mutual fund that charges 2%. That's a very irrational way to price what I think is largely alternative beta...”

Culbertson also expects to see greater creativity in product structuring:

“At Context, we spend a lot of time working with potential managers on what they have done well in their private business and how can they translate that skill set into a product that conforms to the '40 Act as opposed to saying 'I've run this product for 10 years. I want to take this product and put it in the '40 Act world.'”

In addition, he said, managers of the second wave are better prepared for '40 Act regulations:

“Because of the regulatory infrastructure it is an extremely complicated business, especially when you're trying to execute a complicated strategy inside of a complicated structure, so few managers have gone into this with eyes wide open. In the second wave, it's much less the case; most of the managers in the second wave have done their homework and they know what they're up against...”


Izenstark has a slightly different take on the second wave of liquid alts: he thinks it was dominated by ETFs. And he thinks it's over.

Of the main '40 Act structures—open-end funds, closed-end funds and ETFs—it was ETFs that, post-Madoff, were the vehicle of choice for money managers who launched hundreds of them, representing every strategy imaginable. But most, said Izenstark, are not gaining traction and not raising money. Many liquidated after as little as a year.

“The only way that an ETF is really going to survive well is if it's a long-term type of a strategy that fits into somebody's portfolio or a long-term position that they can take, not some kind of a trade,” said Izenstark. “If it's a trade, that makes no sense to me at all...If you're saying that you're coming out with an ETF that's only going to be short Amazon, well, the only time people are going to buy it is when they believe Amazon should be shorted and when it's going up, like it's doing now, no one's going to buy it...”

Izenstark believes there will be many more ETF liquidations as part of the third wave of liquid alternative products, a wave he believes is already here:

“I think we're in phase three,” he said…“[T]he launching by every single mutual fund shop on the planet of a liquid alts strategy.”

Liquid Alts 3.0?

The problem, said Izenstark, is that “most of these strategies have not been tested.”

“You've seen a few tests—second quarter 2013 you saw interest rates go up, you saw TIPS [Treasury Inflation-Protected Securities] get hit really hard…and many of these so called liquid alts or hedged strategies didn't work.”

Culbertson also expects a cull in the liquid alts space—in fact, he considers the recently announced SEC probe of 25 liquid alternative managers as part of that process:

“Anytime there's this much asset flow into a category, the SEC pays attention, and rightfully so...I think it's a healthy, important step in the evolution of the business, quite frankly...[O]ne more step in the process of differentiating better quality businesses from poorer quality businesses. The end investor will end up with a better offering due to this scrutiny.”

Izenstark said that five years out, he expects the liquid alternatives space will be “a lot tighter in the sense that you will have more metrics around the liquid alts space, what it is, where it fits into people's portfolios...”

But Izenstark noted that there's also been a change in liquid alternatives investors: the intermediaries and advisors he deals with have become significantly more sophisticated.

“They know the questions to ask, they know what they're looking for.” And what they're looking for, said Izenstark, is what everyone should look for in a liquid alternative strategy:

“If you do one thing with liquid alts, you will find value—and a strategy that is not highly correlated with the biggest part of a client's portfolio...[I]f you start there, then you're going to find alternatives to the big portion of their portfolio which is a lot different than just saying, 'Okay, anything that's called a liquid alternative I'm going to look at it and see if it's a good strategy.'”

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