28 JUNE 2017 Investors are having a tough time. Interest rates on government bonds are either very low or negative. Stock market valuation, with P/E at 22, is high. Consumer spending and business investments are low. What is an investor to do?
One answer that is gaining increasing traction is: “invest in liquid alternative investments.”
Traditional asset allocation, based on modern portfolio theory, does not provide useful conclusions. Based on the long-term bull markets in stocks and bonds, MPT models construct portfolios of stocks and bonds. Of course, these models are not able to incorporate future trends; these are viewed as extensions of historical trends. Assuming, as I do, that we are entering a new financial regime, these models are of limited usefulness.
What are liquid alternative investments?
What are liquid alternative investments?
They are mutual funds and ETFs that use hedge fund tools and strategies to provide a hedge that limits the downside in falling markets. Liquid alts are able to use leverage, shorting and derivatives to a much greater extent than “traditional” mutual funds and ETFs. This provides the possibility of achieving greater returns with lower volatility that traditional funds. However, it also opens up the possibility of greater losses, especially because of the use of leverage, which amplifies any loss.
Liquid alts have some advantage and drawbacks when compared to hedge funds. In the plus side, they are regulated by the SEC and therefore need to comply with standards of disclosure and liquidity; whereas hedge funds, as limited partnership, are exempt from some (but not all) regulation. In addition, mutual funds have low minimum investments, daily valuation of their portfolios, and investor can sell their shares back to the company at the end of each day. Hedge funds, on the other hand, have high minimum investments (in fact, some are completely closed to new investments) and “lock up periods” which prohibit investors to withdraw their funds for a given amount of time, which can sometimes be as long as a year. Finally, hedge funds report their net asset value at their discretion, which sometimes means investors don’t know the value of their shares for long periods of time.
The greatest difference, however, is that hedge funds can only take investments from “qualified investors,” who have an annual income of at least $200,000 a year ($300,000 for married couples) while mutual funds and ETFs, with very few exceptions, allow anyone to purchase their shares.
This effectively segregates the investors in alternative investments into two groups: the well-to-do and the rest of investors.
How do Liquid Alts Perform?
The performance of liquid alts, mirroring their hedge fund cousins, has been relatively poor over the past few years, lagging far behind the rallies in the bond and stock markets. To some extent, this is to be expected since liquid alt carry short positions, which will be a drag during market rallies. However, the extent of underperformance is discouraging, especially since liquid alts are touted as vehicles that can make money in any market conditions.
A caveat at this point. There are as many as a dozen different liquid alt strategies. The most popular are long/short equity, fixed income arbitrate, M&A arbitrage and managed futures. Each strategy has its own unique risk return characteristics and needs to be evaluated on its own terms. Unfortunately, the comments made above apply to all the strategies over a 5-year period.
This leave another alleged benefit of liquid alts in investment portfolios: that they reduce a portfolio’s overall risk because they are relatively uncorrelated with traditional stock and bond investments. Again, this needs to be looked at strategy by strategy. However, in general liquid alts suffer from a common malady with other investments: their correlation with traditional stock and bond investments increases in times of market turbulence, which is exactly when diversification is needed the most.
So returning to our original question: Should you invest in liquid alternative investments? The answer needs to be a qualified: it depends. The most important point is that liquid alts cannot be treated as a single investment. There are in fact a number of strategies that need to be evaluated on their own strengths and weaknesses. In addition, there is a wise disparity in the results of individual funds within each strategy group, which makes the selection of individual funds crucial to the success of the investment.
In a subsequent column I will address the issue of choosing the “right” liquid alt fund for your portfolio.
Empowering Investors, LLC will help you take charge of your financial future with cost- effective investment products and strategies. Our one-time proprietary Investment Review© places power in your hands. We identify needless investment expenses and assist you in building an appropriate and cost-effective investment portfolio designed to meet your goals and risk tolerance. Founder and principal Ezra Zask has been actively managing, consulting, teaching, advising, writing and speaking on hedge fund and investment management issues for over four decades.