There has been tremendous growth in the assets under management in the liquid alternatives space in recent years, growing from less than $150 billion in 2008 to over $900 billion today. Similar to hedge funds in some ways, and to mutual funds in other ways, liquid alternative funds provide both retail and high-net-worth investors the ability to diversify their portfolios beyond the world of long-only stock and bond funds.
Liquid alternative funds, or hedged mutual funds, offer a wide variety of investment strategies. Investors can access long/short equity, long/short credit, managed futures, commodity, currency, market neutral, and inverse funds in daily liquid mutual fund formats. The fees of liquid alternative funds, at 1 percent to 2 percent of annual assets, are generally lower than hedge funds.
INVESTING IN TRADITIONAL HEDGE FUNDS
Many high-net-worth and institutional investors still prefer private hedge funds, as evidenced by the record $3.2 trillion in assets under management as measured by Hedge Fund Research, more than double the assets in hedge funds at the depths of the global financial crisis of 2008 to 2009. There are pros and cons to investing in private hedge funds structured as limited partnerships. With fees varying from 1.5 percent to 2.0 percent of annual assets, plus 15 percent to 20 percent of profits, hedge funds are not cheap. However, many investors view this level of fees as appropriate, as the private hedge fund structure allows them access to many of the world’s best asset managers and niche investment strategies. While many hedge fund strategies focused on liquid underlying assets such as stocks or futures may require minimum holding periods of up to six months, less liquid hedge fund strategies can require a lock-up period of up to three years. In hedge funds that require longer lock-ups, managers may trade some interesting assets with significant return potential, such as distressed debt, aircraft leases and unlisted stocks.
When investing in hedge funds, investors place significant trust in the manager, often forgoing transparency regarding the specific positions in their portfolio and allowing the manager the ability to take substantial risk regarding liquidity, leverage and concentrated positions in their portfolio. While some investors are comfortable delegating this level of authority to their hedge fund managers, others wonder if the incentive fee structure that pays managers 20 percent of profits without compensating investors for losses gives the manager an incentive to swing for the fences in search of high risk, high returns and high fees. This risk-taking ability may be enhanced by the lack of disclosure requirements.
Perhaps the biggest drawback to hedge funds is that they are not available to retail investors. Hedge funds are relatively unregulated by the Securities and Exchange Commission, as evidenced by the 3(c)1 and 3(c)7 exemptions to the Investment Company Act of 1940. These private placement exemptions exempt hedge funds from disclosure requirements and risk limits if the hedge funds are distributed only to accredited investors and qualified purchasers, which are those with assets exceeding $1 million outside of their primary residence and $5 million, respectively. Investors not meeting these net-worth thresholds are not eligible to invest in private placement hedge funds.
REGULATIONS APPLICABLE TO LIQUID ALTERNATIVE FUNDS
Outside of the anti-fraud requirements applicable to all fund managers, hedge funds are relatively unregulated. Liquid alternative funds around the world must follow one of an increasing number of regulatory structures: The Investment Company Act of 1940 in the United States, Undertakings for Collective Investment in Transferrable Securities (UCITS) in Europe, and National Instrument NI 81-102 implemented in Canada in January of 2019. Each of these strategies limits the holding of illiquid investments to between 10 percent and 15 percent of fund assets.
All mutual funds in the United States, termed ’40 Act Funds, limit leverage through the use of a 300 percent asset coverage rule, which requires assets to be three times the liabilities, allowing maximum leverage of 133 percent. Asymmetric incentive fees are not allowed for funds trading securities such as stocks and bonds, meaning that the 2 and 20 fee structure common in hedge funds is not found in ’40 Act Funds.
The regulations in Europe and Canada are relatively similar, as both UCITS funds and Canadian alternative funds allow the asymmetric incentive fee structure that is prevalent in the private hedge fund industry. These regulations restrict borrowing to two times NAV and gross exposure to three times NAV. All three regulatory structures have concentration rules that seek to maximize diversification and reduce the risk of funds holding all of their assets in just a few investment positions.
As a result of these regulations, we see a difference in the types of investment strategies available in liquid alternative versus private hedge fund strategies. Hedge Fund Research reports that the assets of private hedge funds are relatively diversified across strategies, with the assets allocated to relative value, event driven, equity, and macro/managed futures strategies varying between 18 percent and 29 percent of all hedge fund assets. The picture differs tremendously when moving to the alternative UCITS market, with more than 80 percent of assets held in equity and macro/managed futures strategies that have liquid stocks and futures as the investments as a focus of the underlying strategy. Relative value and event driven funds that hold 53 percent of all private hedge fund assets account for less than 19 percent of alternative UCITS assets under management, as these strategies tend to hold fewer liquid assets or deploy higher levels of leverage than allowed under the regulatory environment that governs the liquid alternative markets. Highly illiquid strategies, such as private equity and distressed debt, are unlikely to be available in liquid alts formats, as these investments cannot typically be liquidated in the short time frame required for liquid alternative funds.
EVALUATING PERFORMANCE OF LIQUID ALTS FUNDS
When choosing between investing in hedge funds or liquid alternative funds, investors must evaluate the relative risk, returns, fees, liquidity and disclosure across the two investment vehicles. A key question is this: Are liquid alternative funds likely to outperform hedge funds due to their lower fee structure or are hedge funds likely to outperform liquid alternative funds due to their ability to take greater risks regarding liquidity, leverage and concentration?
It can be difficult to compare the two investments directly, as liquid alternative funds, like all mutual funds, publish prospectuses, daily NAVs, and semi-annual reports disclosing portfolio positions. As a result of these disclosure requirements, information regarding liquid alternative funds is widely available for the complete universe of funds. Because hedge funds are not subject to these disclosure requirements, databases report information describing only the subset of hedge funds that have volunteered to include information regarding their funds in the various hedge fund databases. The best way to make this apples-to-oranges comparison between complete and incomplete databases is to perform a matched-sample test, comparing the returns of a single hedge fund manager who offers both a liquid alternative fund and a private hedge fund following the same strategy. A Cliffwater study following this methodology came to the conclusion that hedge funds have higher returns than liquid alternative funds. That is, liquid alt funds in the long/short equity, long/short credit, market neutral and macro/managed futures strategies had annualized returns 0.42 percent to 0.94 percent below the returns of hedge funds following a similar strategy. Of course, liquid alternative funds are likely to have lower risk than private hedge funds due to the limits imposed by the various global regulations that govern mutual fund investments. Compared to their lack of ability to invest in private hedge fund products, retail investors might not mind this relatively small return discount to enhance the risk reducing diversification potential in their portfolios.
DEPLOYING LIQUID ALT ALLOCATIONS IN CLIENT PORTFOLIOS
Information regarding liquid alternative funds can be sourced through Morningstar, Lipper, Wilshire and Alternative UCITS. A comparison of liquid alts strategy indices sourced through these databases compared to returns of private hedge funds offers some encouragement, as liquid alternative funds have high correlations to many hedge fund strategies. With correlations of between 0.75 and 0.95 in many strategies, investors can be comforted that the risk/return pattern of liquid alternatives gives them similar strategy exposures and risk management potential to those available in the hedge fund universe.
When building client portfolios to include liquid alternative strategies, advisers should focus on the diversifying potential of each specific liquid alternatives fund. For example, not much diversification potential is available through long/short equity funds, as the correlation to long-only equity markets can exceed 0.9. While the beta of long/short funds may be half of the beta of long-only equity funds, the key risk driver is still the underlying equity markets where most clients have the bulk of their exposure. Diversification potential is much greater in strategies with lower equity market exposure, as there is a negative correlation of the returns to equities relative to the liquid alt strategies of managed futures, bear market funds and volatility funds.
Investors who expect stocks to offer the same 12 percent annual returns in the next decade as those experienced since the bottom of the global financial crisis have no need for liquid alternatives, as most of these strategies are not designed to offer returns in excess of public equity markets during a continued bull run. However, the primary outcome of liquid alternative investments is to mitigate losses during times of large equity drawdowns. For example, a balanced portfolio of stocks and bonds experienced a 33 percent drawdown in 2008-2009. Introducing a 10 percent allocation to the most diversifying liquid alts strategies would have reduced that drawdown to between 27 percent and 29 percent, a relatively large risk reduction for a small allocation to liquid alts. Those interested in greater hedging potential could have allocated up to 30 percent of their portfolio in liquid alts and experienced drawdowns in the range of 20 percent to 23 percent during 2008-2009. Investor psychology is important, as those experiencing a loss of one-third of their capital may be tempted to reduce their allocation to equities at the bottom of the market, locking in their losses when stocks are at the lowest prices in a generation. Those who had allocated generously to alternative investments, especially managed futures that earned average gains of 18 percent in 2008, may have more easily overcome the temptation to sell at the crisis market lows, especially when their drawdown of 20 percent compares favorably to those of their colleagues and neighbors who may have experienced losses of 50 percent or even more if fully allocated to equities in the crisis.
Remember that investing is a long game. Building an asset allocation designed to last 10 to 30 years has little value if investors sell in year five and crystallize large losses due to fears of substantial and continuing losses in a bear market. But taking advantage of the maximum diversification potential available, either in hedge funds or liquid alts, can reduce portfolio risk, as well as the behavioral finance induced temptation to liquidate at the bottom of the market. While adding hedge funds or liquid alts to a portfolio may slightly reduce portfolio returns in the long run, relative to staying invested in a portfolio dominated by holdings in equity markets, the smoother ride of a lower risk, more diversified portfolio may make sense for average investors and even more sense for the risk-averse.
Keith Black is managing director of curriculum and exams at the Chartered Alternative Investment Analyst Association.