Liquid Alternatives: Active Management Makes A Comeback

Jan 13 2015 | 8:53am ET

By Jessica Lynn Rabe
Research Associate, Convergex
Co-Author, Alts Democratized: A Practical Guide
to Alternative Mutual Funds and ETFs for Financial Advisors

The pendulum that swung hard towards passive management with the innovation of exchange-traded funds is finally swinging back towards active management. ETFs have disrupted portfolio design for institutional and retail investors since the 1990s, but mutual fund companies are striking back with concentrated alpha in the form of liquid alternatives. Liquid alts are experiencing a sustained period of rapid growth, and this may parallel the early days of ETFs.
Liquid alts are garnering significant new money flows. Total net assets of liquid alts rose by 130% over the past five years, totaling +$340 billion as of December 31, 2014, according to preliminary data from Lipper. Assets have grown sevenfold in 10 years. Goldman Sachs believes they are “capable of producing a $2 trillion AUM opportunity” over the next 5-10 years—a threshold crossed by ETFs just last month.

Here is a breakdown of this burgeoning asset class:
• Liquid alternatives are hedge fund strategies in the form of Investment Company Act of 1940 wrappers, such as a mutual fund or exchange-traded fund.  The definition of liquid alts continues to change and evolve as classifications of these funds are subject to various interpretations by data providers, and reclassifications occur frequently. Lipper, for example, splits liquid alt strategies into eleven classifications.
• Liquid alts can go long and short in equity, fixed income, currencies, commodities and derivatives instruments. These funds democratize alternatives by providing retail investors with access to hedge fund strategies that were previously limited to high net worth individuals and institutions through traditional hedge funds.
• Bear in mind that liquid alts have restrictions on leverage and liquidity that prevent them from entirely replicating hedge fund strategies. Consequently, performance is often diluted relative to traditional hedge funds.
• Nevertheless, liquid alts provide benefits compared to traditional hedge funds, including better investor protection and greater transparency.  Liquid alts have disclosure requirements that afford these benefits. They also sport lower investment minimums and expense ratios, and can be more tax efficient as well.
What do liquid alts have to offer beyond the typical stock to bond mix?

Alternative mutual funds and ETFs are best used as complements—as opposed to substitutes—to a portfolio’s stock or bond exposures. This is an important distinction and one that should help rejuvenate interest in active management. ETFs capture beta efficiently and cheaply, and are thus well suited for the core of a portfolio. Conversely, liquid alts capture concentrated alpha in the satellite of a portfolio, which can greatly improve the risk/return profiles. Here are five roles that liquid alts can play in portfolios:
• Portfolio Diversifier: These strategies are uncorrelated to traditional asset classes, such as stocks, bonds, and real assets. Inclusion of these strategies can help mitigate portfolio volatility. For example, Alternative Managed Futures Funds use algorithmic volatility management and trend-following strategies that go long or short in derivatives, commodities, financial assets, and exchange rates. These funds have limited beta exposures to stocks and bonds, thereby improving the diversification profile of a portfolio. Managed futures grew in popularity after outperforming during the financial crisis. They often earn modest returns during bull markets, however, due to their low correlations to financial assets like stocks. Alternative Managed Futures Funds earned 9.56% in 2014 according to preliminary Lipper data.
• Equity Complement: These strategies are highly correlated with equities and provide the potential for alpha generation. For example, Alternative Long/Short Equity Funds “employ portfolio strategies combining long holdings of equities with short sales of equity, equity options, or equity index options,” as defined by Lipper. The use of leverage in these funds can enhance a portfolio’s returns, although funds with high equity tilts amplify risk. This strategy is among the most popular Lipper liquid alternative classifications with +$35 billion in total net assets. Alternative Long/Short Equity Funds gained 3.30% in 2014, and its 3-year average annualized return is 7.98% according to preliminary Lipper data.
• Fixed Income Complement: These strategies are correlated with bonds and have a similar risk/return profile. They are particularly of value for investors seeking enhanced income in the current low yield environment. Alternative Credit Focus Funds serve this role effectively by diversifying the fixed income portion of a portfolio and by hedging the equity allocation. They also provide active management of credit risk and duration risk, an attractive feature as the Federal Reserve’s rate decision looms. This helps explain the classification’s inflows of +$36 billion in 2014. Alternative Credit Focus Funds is the largest classification by total net assets out of Lipper’s eleven liquid alternative classifications with +$117 billion.
• Tactical Hedge: These strategies act like term insurance, and provide targeted protection for a short period: they have modest expected returns under most environments and high expected returns during fat tail events. For example, Alternative Currency Strategies Funds can help hedge the currency exposure of foreign stock and bond positions by making strategic bets on the direction of a currency. Bear in mind that these funds are volatile and lost 3.10% in 2014, according to preliminary Lipper data.
• Directional Bet: These strategies are typically reserved for the big leagues:  professional traders and investors employ directional bets for tactical or hedging purposes using dedicated short funds, leveraged ETFs, or currency funds. Many funds are highly leveraged and result in wide dispersions of returns. Dedicated Short Bias Funds, for example, aim to capture the inverse or negative multiple of an index’s return on an asset class or a leveraged bet on a benchmark; they returned negative 14.36% in 2014.
Understanding these roles and the underlying factor exposures of liquid alts is essential in order to intelligently include liquid alts in a portfolio. The largest misconception with these funds is how they perform in different market environments. Liquid alts are—for the most part—uncorrelated to stocks, and typically lag during bull markets. Misunderstanding this relationship will leave investors disappointed, although the payoff profile is much more “Feature” than “bug”. 
With that said, liquid alts are especially useful for volatility management. These strategies are in a sense, a source of psychological alpha due to their uncorrelated characteristics: they increase portfolio diversification and can mitigate portfolio volatility. By longstanding tradition, many portfolios have held cash or gold for these reasons. Liquid alts help investors endure market volatility by encouraging discipline during times when they are vulnerable to panic and irrational investment decisions. They help reduce bailout risk (selling at the bottom) during market downturns and enable investors to hold a greater exposure to equities through an investment cycle.
Liquid alts are not for every investor, but this asset class represents a huge growth opportunity that warrants your attention. These strategies help achieve goals ranging from diversification, enhanced income and hedging of tail risks, to preservation of capital and active management of credit and duration risks. Moreover, a continued breakdown in asset price correlations will benefit asset managers as returns show greater dispersion, which should in turn benefit liquid alts. Investors need to just make sure they choose managers and funds prudently, and keep their expectations in check.
In summary, liquid alts seem to have a bright future, and that’s good for investors and active money managers alike. The former has a new tool to manage risk. The latter finally has a growth engine after +10 years of an industry shift to passive management.  While it may take another market downturn to really turn up the wick on this story, liquid alts are clearly the next big thing.  If you are interested in learning more about liquid alternatives, please check out Robert J. Martorana, CFA and my new book: Alts Democratized: A Practical Guide to Alternative Mutual Funds and ETFs for Financial Advisors.
Jessica Lynn Rabe is co-author of Alts Democratized: A Practical Guide to Alternative Mutual Funds and ETFs for Financial Advisors with Robert J. Martorana. Rabe is a research associate at Convergex, a global brokerage company based in New York. She assists the firm's Chief Market Strategist in publishing the Convergex Morning Briefing, a daily commentary on financial markets.

Rabe is also a contributor for the American Enterprise Institute's Values and Capitalism blog, and has been published by the World Economic Forum's Global Information Technology Report, Asset International's Strategic Insight Alternatives Quarterly, Seeking Alpha, and Center for Public Justice.

Previously, she was a research analyst at Right Blend Investing, LLC, a Registered Investment Advisor, where she published articles and contract research on the liquid alts industry.

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