5 steps to understand Liquid Alternatives: Pros and Cons

5 steps to understand Liquid Alternatives: Pros and Cons

Introduction to Liquid Alternatives

Liquid alternatives, also known as liquid alts, are a class of mutual funds and ETFs that aim to provide retail investors with access to alternative investment strategies typically used by hedge funds.

Key Features

  • Provide daily liquidity unlike traditional illiquid alternatives like hedge funds
  • Lower investment minimums than hedge funds, allowing smaller investors access
  • Offer potential for diversification and reduced volatility
  • Implement strategies like long/short, market neutral, managed futures, arbitrage among others

Liquid alternatives expanded after the 2008 crisis as investors sought diversifiers. But critics argue high fees and liquidity concerns.

 Growth and Criticism of Liquid Alternatives

  • Liquid alt AUM hit a new record in 2021, rebounding from declines in prior years. Almost all Morningstar categories saw positive net inflows.
  • After years of net outflows, 2021 saw the strongest liquid alt inflows since 2013, totaling $55 billion.
  • The growth has been attributed to strong performance in 2021 and increased investor demand for diversification.
  • Top performing liquid alt categories in 2021 included commodities, energy partnerships, and real estate.
  • Calamos Market Neutral Income was the top selling liquid alt fund in 2021.
  • Projections point to continued AUM growth and net inflows into liquid alts in 2022 and beyond.

What are liquid alternatives?

Liquid alternatives, also known as liquid alts, are publicly traded mutual funds or ETFs that invest in alternative asset classes and employ investment strategies typically used by hedge funds. They aim to provide the diversification and risk management benefits of alternatives while offering daily liquidity, lower investment minimums, and regulatory oversight compared to traditional hedge funds.

Key characteristics:

  • Provide daily liquidity, unlike traditional illiquid hedge funds
  • Lower investment minimums than hedge funds
  • Offer diversification through exposure to alternative assets like commodities, currencies, real estate
  • Implement hedge fund strategies like long/short, market neutral, managed futures
  • Registered under the Investment Company Act of 1940 and regulated like traditional funds

Growth of the liquid alts market:

  • Assets under management in liquid alts hit record highs in 2021 after years of declines
  • Strongest inflows since 2013 totaling $55 billion in 2021
  • Resurgence attributed to strong performance in 2021 and demand for diversification

Strategies and objectives:

  • Diversification and reduced correlation to stocks and bonds
  • Lower volatility and downside risk
  • Enhanced risk-adjusted returns compared to long-only funds
  • Inflation and tail risk hedging abilities

Key strategies: long/short equity, market neutral, managed futures, global macro, arbitrage, event driven, relative value

Role in a portfolio:

Liquid alts can play various portfolio roles like core holding, complement, inflation hedge, or return enhancer depending on objectives. Proper asset allocation is key.

In summary, liquid alternatives aim to make hedge fund strategies accessible to retail investors through daily tradable mutual funds and ETFs, providing an additional option for diversification and risk management.

Evaluating and Selecting Liquid Alternatives

Key factors to consider:

  • Investment strategy and philosophy
    • What is the fund’s approach? Long/short, market neutral, macro, etc.
    • Is the strategy clearly defined?
    • Does the strategy make sense given the fund’s stated objectives?
  • Portfolio transparency
    • How much visibility into holdings is provided?
    • Are position-level details disclosed regularly?
  • Risk management practices
    • What risk controls are in place?
    • How is leverage monitored and managed?
    • Are stress testing and scenario analysis used?
  • Fees and expenses
    • Management fees, incentive fees, other fund expenses
    • How do costs compare to similar funds?
    • Are fees justified given the strategy?
  • Track record and performance
    • How long has the manager been running this strategy?
    • Risk-adjusted returns over full market cycles
    • Performance attribution – what drove returns?
  • Manager pedigree and team
    • Experience and expertise of the portfolio management team
    • Stability of team and firm
  • Fund terms
    • Liquidity terms – daily, monthly, quarterly redemption
    • Investment minimums
    • Lock-up periods
  • Assets under management
    • Is the fund size appropriate for the strategy?
    • Can the manager still implement the strategy effectively?
  • Use of leverage
    • How is leverage monitored and managed?
    • What are the maximum leverage limits?

Conduct thorough due diligence and have clear objectives when selecting liquid alts to incorporate into a portfolio.

Role of Liquid Alts in a Portfolio

Liquid alternatives can play various strategic roles in a portfolio depending on an investor’s objectives, risk tolerance, and desired outcomes.

Inflation and Tail Risk Hedge

Many liquid alts aim to provide diversified exposure to real assets like commodities, real estate, and infrastructure. This can make them effective inflation hedges as they may appreciate with rising prices. Strategies like managed futures and global macro that dynamically shift exposures can also potentially hedge tail risks during periods of market stress.

Core Holding and Diversification

Used as a core holding, liquid alts can provide broad exposure to alternative strategies and asset classes, enhancing diversification versus traditional stocks and bonds. This aims to smooth out portfolio volatility and reduce drawdowns.

Asset Allocation and Professional Advice

Proper asset allocation is crucial when adding liquid alts to a portfolio. Their complexity warrants advice from investment professionals on strategy selection and portfolio integration.

Complementary Satellite Holding

As a satellite, liquid alts complement core holdings like stocks and bonds. This additional diversifier aims to boost risk-adjusted returns.

Enhanced Return Generator

Certain liquid alt strategies like equity long/short can pursue enhanced returns versus long-only funds. However, these tend to carry higher correlation to equities.

In summary, liquid alternatives can play multiple strategic roles depending on desired portfolio outcomes. Professional advice on allocation is key to balance risk versus return.

FAQs on Liquid Alternatives

What are liquid alternatives?

Liquid alternatives are publicly traded mutual funds and ETFs that aim to provide daily liquidity and access to alternative investment strategies like those used by hedge funds. They offer features like:

  • Lower investment minimums than hedge funds
  • More transparency into holdings and strategies
  • Regulatory oversight as registered investment companies
  • Potential for diversification and lower volatility

Key strategies used include long/short equity, managed futures, market neutral, global macro, and arbitrage approaches.

What are the advantages of liquid alternatives?

Advantages of liquid alternatives include:

  • Portfolio diversification from traditional asset classes
  • Lower volatility and downside risk management
  • Potential for risk-adjusted returns exceeding long-only funds
  • Liquidity through daily trading unlike illiquid hedge funds
  • Increased accessibility to retail investors
  • More transparency into holdings and strategies

Are liquid alternatives suitable for all investors?

Liquid alternatives may not be suitable for all investors. Key considerations include risk tolerance, time horizon, liquidity needs, and ability to take on complexity. Conservative investors focused on capital preservation may be better suited to traditional investments. Investors should understand the risks and have clear objectives before investing in liquid alts.

How do liquid alternatives work?

Liquid alternatives use mutual fund or ETF structures to implement hedge fund strategies like short selling, leverage, derivatives, and dynamic trading. Portfolio managers combine these alternative approaches with traditional assets. The goal is to enhance diversification, smooth volatility, and provide differentiated drivers of return versus plain vanilla stock and bond funds.

How do I invest in liquid alternatives?

Liquid alts can be purchased like traditional mutual funds or ETFs through brokerage accounts. Leading providers include BlackRock, Fidelity, Goldman Sachs, and Invesco. Minimum investments are typically $1,000-$5,000. Assessing suitability, strategy fit, expenses, and risks is key before investing in liquid alternatives.

Leave a Reply

Your email address will not be published. Required fields are marked *