There are obvious hurdles when it comes to motivating investors to move from products they know well, into something different — especially when performance has been satisfactory. Managers, advisers and asset owners have not been terribly challenged during the past decade, and the alternative product space has done little to entice investment dollars in what’s been a highly competitive period. Recent volatility may certainly trigger questions about the status quo, but new fee structures and innovations may offer increased impetus for portfolio modifications.

Motivating the need to move in a new direction is the fact that nearly every major U.S. wirehouse has significantly reduced capital market expectations. Even before the COVID-19 pandemic thrust many developed nations into, or close to recession, the consensus had already projected significantly reduced portfolio returns, especially related to core fixed-income expectations. As overall returns diminish and volatility increases, asset owners will need to look beyond the common investment products and into more specialized vehicles.

The “alternative” moniker encompasses a wide swath of products, with massive variations in risk, return, correlation and usage. In this space, I’m focused on the “alternative income” and “market neutral” strategies, typically benchmarked to short-term cash markets and rated on their ability to de-correlate from other assets such as stocks and bonds, while potentially delivering excess returns. Different substrategies within alternative income funds may also include long/short credit, market neutral and multi-alternative. All can be used to potentially achieve distinctive results based on the goals of the manager.

DEFINING ALTERNATIVE TRAITS

Liquid alternatives historically have a low correlation to equity markets. Over the past five years, many alternative strategies have had a volatility profile of one-third that of equities or less, according to Morningstar data (as of Dec. 31). In 2019, actively managed alternative funds6 — including long/short credit, market neutral and multi-alternative strategies — averaged 1.92
percent in fees, with a median return of 6.29 percent, net of fees.

In response to the pandemic, the Federal Reserve has dropped rates effectively to zero. On top of the rate cuts, the Fed has already committed to $4 trillion of stimulation in an effort to keep rates low and credit markets functional. Coupled with an overall flight to quality, 10-year yields are now less than 0.75 percent as of April, and it’s likely prevailing factors will continue to pressure rates in the intermediate term. Put simply, bond investors will need to work extra hard to achieve results.

Added volatility in equities and questions around future economic health may further pressure investors to seek alternatives to achieve performance goals. If utilized and structured properly, alternatives do have the potential to help mitigate drawdowns in other asset classes as part of a balanced portfolio. That said, it’s important to remember that just because an investment is deemed “alternative,” it’s not necessarily going to offset reduced income from bond yields or offer a hedge from a slowing or falling market.

There is, of course, one drawback to many alternative funds out there: fees. According to Morningstar, since 2015 only the nontraditional bond category had more than 50 percent of mutual funds (institutional share classes) outperform the Bloomberg Barclays Aggregate Bond Index net of fees. More disappointing were the multi-alternative, market neutral and long/short credit categories with only 22 percent, 25 percent and 44 percent, respectively.

Looking back over the past five years, the above categories averaged 40.5 percent in net expenses. The multi-alternative and market neutral alternative categories were the highest with average net expenses of 53 percent and 61 percent of gross returns, respectively. These large relative costs don’t seem to make sense for those seeking low-risk, bond-like returns.

Investors seeking returns that are de-correlated to equities, with relatively low volatility, may wish to consider a fund strategy that utilizes a market neutral approach. These types of funds may combine two or more complementary strategies such as shorter-dated, yield-oriented strategies, convertible arbitrage tactics, and macro hedging strategies, which have the potential to deliver positive returns regardless of the direction of markets. But perhaps equally as important as the style of alternative funds is the fund’s fee structure and how the incorporation of a performance fee based on excess return could be beneficial.

We challenge investors to explore the fee structure options of whatever alternative fund they select as it could have a substantial impact on performance, especially during periods of high volatility or low fixed-asset returns.

TIME IS RIGHT FOR FEE INNOVATION

Given the relatively high expense ratios of most fixed-income alternatives, one can logically assume the relatively cheap, flat fees in the competitive ultra-short-term bond category were enticing. But according to Morningstar data, the ultra-short-term bond category averaged a net return of just 2.03 percent, with an average expense ratio of 0.49 percent over the last three years. As rates continue to decline, even those returns may be harder to come by.

Short-term bond funds, those which invest in bonds maturing in less than five years, tend to perform well during periods of declining interest rates. But as the declining rate cycle ends, and a period of flat or even moderately rising interest rates takes hold, the average short-term bond fund is likely to be strained, especially those without active intervention. We believe that properly priced alternative income strategies have the potential to fill this void and serve as a risk-mitigation tool for advisers and investors alike.

WHY VARIABLE FEES MAKE SENSE

In a space where average fixed fees in some income alternative categories have consumed more than 50 percent to 60 percent of gross returns, it is important to strike a better balance between investors’ objectives and manager incentives. To best accomplish those goals, new innovations offer lower, graduated fixed fees as well as a variable fee structure that separates the cost of beta and alpha. These structures allow investors migrating from cheaper, passive products to pay a similar base fee (just as they would with passive), but with the added potential for outperformance, paying active managers an additional fee only when it’s earned.

A variable fee with a low beta cost helps mitigate the problem of high fees and low returns for investors. These structures may help better align with the investor by not charging high fees when a fund fails to generate excess returns and only having the investor pay a proportionate fee as a share of value-added performance. Investors can also take comfort in their ability to capitalize on periods of outperformance as all fees are capped.

THE LONG TRACK RECORD Of VARIABLE FEES

Variable fee constructs, sometimes called “fulcrum fees,” have been around for a long time; however, their formulation has typically favored the manager, with base fees uncorrelated to beta costs and upside incentives and/or fee caps too high. Using performance data and manager ranking, new performance-based fees can bring potentially unprecedented, asymmetric fee advantage to the client.

Under a sensibly aligned structure in an absolute return strategy, investors have the potential to maintain relatively low volatility, a negative correlation to bonds and a low correlation to equities.

Harvey Steele is senior vice president and head of intermediary distribution at Westwood.