One Year, Three Lessons: What Launching A Liquid Alternatives Fund Taught Us

Sep 24 2015 | 1:53pm ET

Editor’s Note: David Katz is president and COO of fund of hedge funds investor Larch Lane Advisors, which formed a joint venture with Rothschild Asset Management in August 2014 to manage the new liquid alternative Rothschild Larch Lane Alternatives Fund.

One year into the venture, Katz shares three key lessons for financial advisors and investors from the manager’s perspective.

One Year, Three Lessons: What Launching a Liquid Alternatives Fund Taught Us about Markets, Human Nature and Diversification 

By David Katz

Until recently, investors were piling into the S&P 500. On the surface, it’s hard to argue with six years of a bull market. It’s human nature to want to be part of that. But savvy investors know to look under the surface, to check for hidden vulnerabilities in their portfolios and investing style. 

As we celebrate the first anniversary of our liquid alternatives fund, it seemed like a good time to assess what a year in the liquid alts trenches taught us – and how those lessons might be valuable for other investors. 

Here are some lessons from our inaugural year: 

1) Performance and Liquidity Can Co-Exist

There’s a long-running debate about how to achieve the right risk-adjusted performance without giving up liquidity – or whether it can be done at all. How should investors think about the balance between liquidity and performance? Do they need to make trade-offs or is that a false choice? 

Our experience shows that it’s possible for performance and liquidity to co-exist; you just have to go about it in the right way. While the Rothschild Larch Lane Alternatives Fund is just a year old, we applied 20 years of experience in investing in hedge fund strategies. We studied how they perform individually and how they perform in combination. 

We took these time-tested strategies and combined them in a way that provides diversification and meets the desired risk-return profile – without giving up anything. 

Not only is it possible for performance and liquidity to co-exist, a liquid portfolio also offers specific benefits. As opportunities arose, our subadvisors were able to adjust exposures dynamically.  

2) Most Investors Have Too Much Equity Exposure 

One common belief about hedge funds is that they are uncorrelated to broad equity markets. That’s often not the case, and it’s a myth that can have serious consequences. Long-short equity hedge funds, for example, maintain higher correlations to the equity markets than one might think.  Many liquid alternatives funds are long-short equity funds. Investing in these types of strategies is common and by doing so, investors often introduce more equity risk into the portfolios – exactly what they don’t need.  

How does it happen that long-short equity is so predominant? First, there’s a preponderance of long-short equity managers. Second, it’s what people understand and they gravitate to what makes them feel comfortable. 

Our goal was to construct a multi-manager portfolio that would not necessarily add more equity risk. We utilized what we believe to be the right subadvisor and strategies that, when combined, would be less highly correlated to equities. This included a mixture of currencies, global bonds and commodities. Today’s hot trade can be tomorrow’s loser, and diversification and disciplined risk management are essential to help mitigate losses.

3) There Could be a Market Shakeout Coming 

There has been a surge of new managers and a tremendous amount of product proliferation.  There are new funds coming to market every day. Inevitably, however, the stream of new managers will slow, and there will be a bifurcation between high-quality funds and funds that are not. What will be left ultimately is a smaller number of higher-quality products attracting most of the assets. We are reminded every day that it’s good to stay agile and focused on long-term prospects. 

Just over a year into the Rothschild Larch Lane Alternatives Fund, we have a new appreciation of just how quickly the market is changing and why it’s crucial to stay on top of pitfalls and opportunities. If the year has taught us nothing else, it’s that digging under the surface is critical, diversification pays off and the unexamined portfolio is probably not worth investing in. 

David Katz is President and COO of Larch Lane Advisors LLC, a pioneer in early stage hedge fund investing.

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