future of liquid alternative investments

Will Liquid Alternative Investments Last?

There’s been a growing popularity within the investor universe for what the industry is calling liquid alternatives (liquid alts). Liquid alternatives are products available through mutual funds, ETF’s, and closed-end funds that provide investors with the liquidity of the public markets with the potential low correlation and downside protection inherent in traditional, illiquid alternative investments. Liquid alternatives are formed in accordance with the Investment Company Act of 1940, and are commonly classified as ’40 Act Funds. In accordance with these rules, the fund must maintain 85% or more of the portfolio in liquid assets.

Liquid assets are defined as assets that can be liquidated within a single business day. Additionally, short selling is limited. These funds must be able to cover the full value of liabilities created by short selling, with that amount held as collateral in a separate brokerage account to cover potential loss. The use of leverage is also limited to 33% with separate collateral requirements covering much of this leverage risk. Many of these traits like use of leverage and short selling are staples of hedge fund and private equity strategies. While it’s possible for some of these liquid alternative funds to exhibit return characteristics of traditional alternatives, there are limits to what these instruments can do due to regulatory constraints requiring a liquidity standard. Conversely, traditional alternative asset classes like hedge funds and venture capital are less constrained by regulation, but have exposure to higher risk with potential for increased returns due to their illiquidity.

future of liquid alternative investments

According to a recent Barron’s article, liquid alternatives are growing significantly as an asset class. Assets have more than doubled since 2010 to $449Bn, and the number of liquid alt mutual funds has grown from 202 to 581 within that same period. Much of this increased interest has come as a response to jitters after the 2008 financial crisis. Out of the fear of getting burned by stocks and bonds, investors are seeking to diversify risk and dampen volatility. Additionally, most of these funds are bought through financial advisors in response to their clients’ changing demands. Barron’s explains that financial advisor allocations to this asset class range between 3 to 15%, although many of these advisors plan on raising allocations in the coming months. The impetus behind the rise in allocations is a response to the current market environment. This is the fear of dealing with the sixth year of a continuous bull market (when does it end?) and historically low interest rates for low yields on bonds (when will the Fed raise rates?). After the crisis, investors and their advisors are obviously changing their investment priorities from an emphasis on returns to a focus on capital protection and diversification.

The SEC recently announced in early 2014 that it would conduct a review of these new liquid alternative products. This is due to the novelty and growing popularity of the asset class as well as obvious regulatory concerns. Due to the liquidity requirements for liquid alternatives, equity long/short strategies are popular. Returns for these funds have generally been lower than broader market returns. As mentioned in the Barron’s article, one of the biggest liquid alt funds, the $6.4Bn Mainstay Market field fund, fell 13% in 2014. Two long/short funds that have been successful but have a high correlation to the S&P 500 are Diamond Hill Long-Short at $4Bn AUM, and Neuberger Berman Long Short at $3.4Bn AUM. Multi-strategy funds, including the Natixis ASG Global Alternatives, returned investors 6% over the last five years. The AQR Managed futures fund has shown good performance as well.

The real test will be how these strategies perform in a bear market. Fund managers are cautious that due to the limits on leverage and adherence to a liquidity standard, liquid alternatives are heavily correlated to the broader market. This poses an issue as one of the key traits of alternatives that makes this asset class so desirable is its lack of correlation to traditional assets. True illiquid alternatives such as hedge funds, venture capital, private equity, and fixed income products have the potential to enhance portfolios by creating a way for investors to preserve capital and diversify market risk.


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