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Liquid Alternatives: Take the Time to Get to Know Them

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Written by: Patrick St. Denis | Spouting Rock Financial

There is almost total agreement that diversification is a powerful tool and that when properly utilized, can smooth returns and provide risk (drawdown) mitigation.  Even though the inclusion of alternative investments has been proven time and again to provide diversification benefits by providing differentiated sources of return while also reducing the volatility of an investment portfolio, many investors still do not allocate to alternatives. So why don’t more investors further diversify their portfolios outside of stocks and bonds?  We find that in most cases, it is because of a lack of knowledge and understanding surrounding alternative investments.

The inclusion of alternatives in a portfolio may not have enhanced the absolute return of a traditional 60/40 portfolio during the bull market that followed the 2008 Financial Crisis.  However, an allocation of up to 25% to alternatives would have improved a portfolio’s overall risk-return ratio even in this period of predominantly low volatility.¹  Given the more recent increased volatility in the equity markets and the uncertainty surrounding Fed Policy, now is a crucial time for investors to refocus on alternatives and how best to access them.  The great news is that alternatives are far more accessible now than pre-crisis thanks to the growth of Liquid Alternatives, i.e. mutual funds whose portfolio managers (or sub-advisers) employ strategies similar to that of hedge funds. 

PIMCO’s recent white paper entitled “Liquid Alternatives: Considerations for Portfolio Implementation” is quite timely.  It provides investors a background on Liquid Alternatives, focusing on the evolution and return characteristics of the universe.  We thought it would be helpful to expand on their introduction and provide a layer of insight as to how we at Spouting Rock look at the universe, think about investment due diligence and ultimately proceed with fund/manager selection of Liquid Alternatives.  As experienced hedge fund and Liquid Alternatives investors, we hope that by providing additional insight to our due diligence framework it might aid the investor community in understanding the vast differences that exist between funds, leading to more informed allocation decisions.

Since the Financial Crisis, more and more investors have been using Liquid Alternatives to gain access to alternative investments. 

Investors have been attracted by their regulated status, high level of transparency, low investment minimums, low fees and the daily liquidity they provide. As regulated products, Liquid Alternatives are subject to restrictions on the instruments and leverage that their portfolio managers can employ, which limits the implementation of the full hedge fund strategies in some cases. 

Since 2008, the Liquid Alternatives universe has experienced a steady rise in assets under management (AUM) to $300 billion and an expansion in the breadth of funds to beyond 600², making due diligence on the universe a challenge for most advisors.  Investors generally hire and build teams dedicated to due diligence, selection and monitoring of hedge fund investments; however, there are far less resources committed to Liquid Alternatives fund selection and portfolio management.  Resultantly, the funds with the greatest name recognition and largest marketing budgets have gathered the majority of the assets in the space, rather than those with the best track record and/or who we would consider to the most skilled portfolio managers.  We have witnessed and believe that the quality of funds will continue to improve as talented managers seek to adapt their strategy to meet the growing investor demand for Liquid Alternative funds.     

Morningstar, as the “go to” resource for mutual fund research, categorizes Liquid Alternatives as either “Alternative” mutual funds or “Non-traditional bond” mutual funds.  The majority of Liquid Alternative funds are further broken down into the sub-categories on Morningstar: Equity Long/Short, Equity Market Neutral, Nontraditional bond, Multialternative and Managed Futures.  Investors should be mindful that these five general sub-categories are not always representative of the risk-taking or specific hedge fund-like strategies of the funds they characterize.  Investors should also note that within the five general sub-categories, there are approximately 20 different hedge fund-like strategies that the 600+ funds employ.  Potential investors should be cognizant of the vast differences that exist between funds even in the same sub-category, including strategy, style, philosophy, portfolio construction and risk management. 

To an investor who is unfamiliar with hedge fund-like strategies, knowing and understanding the risks (directional and otherwise) taken by the individual alternatives fund manager is the most important aspect of the research process.  We believe that the manager’s returns are driven by their investment skill and their ability to execute a repeatable investment process.  Our review generally begins with a thorough evaluation of the marketing materials and a call or meeting with the portfolio manager and/or sub-advisor to gain a better understanding of the strategy and manager’s investment history.  Part of this qualitative review involves challenging their investment process and trying to understand how the fund has and would perform under various scenarios.  We supplement this qualitative review with a thorough quantitative evaluation, back-testing the returns to determine the underlying factors involved in their performance.

Since many Liquid Alternative funds have not been around for very long and have short track records, funds like to list the years of experience of their managers alongside their offerings but only a deeper dive into a manager’s experience will bear useful information for due diligence and analysis.  Taking this point a step further, many Liquid Alternative funds are sub-advised by managers who had previous or current lives at other firms with real track records that can be analyzed.  This track record analysis should be conducted keeping in mind any differences that might exist in regard to investment strategy, risk management resources, fund structure restrictions (hedge fund vs. mutual fund), etc.  For example, a hedge fund manager may have generated past returns using more gross leverage than is allowable in a mutual fund product (130%).  When this strategy is modified so that it meets regulatory requirements, returns may be more muted than the hedge fund version, all things being equal. 

Asset allocation in the traditional framework is challenging because Liquid Alternatives are a disparate collection of strategies with different return streams that vary over time. 

It is much more difficult to bind them together as one asset class as is done in fixed income or equities.  We find that allocating to a diversified portfolio of Liquid Alternative funds could potentially add an additional layer of diversification to a portfolio.  We would argue that a total allocation to alternative investments up to 30% is warranted but let’s focus on crossing the threshold first for the majority of investors.

PIMCO’s white paper is timely because prior to August 2015 most investors have not experienced a significant drawdown since the Financial Crisis.  Well, this is what it feels like.  This time around, stocks have not bounced back to new all-time highs with the same swiftness as they had following the Taper Tantrum of 2013 or September-October 2014 selloff.  Drawdowns hamper the statistical dynamic of compounding returns of wealth builders, and in some cases they destroy retirement plans of those just prior to transition.  Thanks to Liquid Alternatives, adding alternatives (diversification) to a traditional equity/bond portfolio mix has never been easier.  However, researching and allocating to alternatives remains a task that should not be taken lightly or dismissed by following the herd. 

¹ Spouting Rock, data for 1/1/1999 to 8/31/2015. “60/40” refers to the returns of a portfolio that is 60% S&P 500 TR Index and 40% Barclays US Aggregate Bond Index; “Alternatives” refers to the returns of the HFRI Hedge Fund Composite Index, which serves as a proxy.  The HFRI Fund Weighted Composite Index is a non-investable, global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in US Dollar and have a minimum of $50 million under management or a twelve (12) month track record of active performance.  An investment cannot be made directly into an index.  Risk is the annualized standard deviation of monthly returns.  Return is the annualized return of monthly returns.  Return and risk are annualized in USD.  This hypothetical example is presented for illustrative purposes only and does not represent the performance of any particular investment.  Past performance is not a guarantee of future results.
² “Liquid Alternative” universe statistics sourced from Morningstar Direct
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