The tech bubble and global financial crisis highlighted the need for diversification in client portfolios. There is ample research illustrating the use of alternative investments can improve the risk/return profile over the long term by helping to reduce volatility, differentiate sources of returns and create a more consistent return stream.

Liquid alternatives — which are funds that invest in assets other than long-only stocks or bonds — provide access to strategies previously only available to high-net-worth investors and institutions.

Access to strategies intended to help investors grow and protect their portfolios may be beneficial, although it is not without risk. Liquid alternatives managers may invest in complex strategies that investors are unfamiliar with, which could lead to a misunderstanding of how a fund will react in different market conditions leading to inappropriate buys, sells and allocations to a fund. In March 2014, Andrew Bowden, director of the Office of Compliance Inspections and Examinations of the SEC, described liquid alternatives as the “bright, shiny object … but they are a sharp object.” Just because a fund is registered and traded on an exchange does not mean it isn’t complex. Complex products require heightened supervision, adequate due diligence, training of registered persons and documentation of these processes.

DEFINING LIQUID ALTERNATIVES

There’s no exact definition of a “liquid alternative.” It is a broad category that is any publicly registered fund that invests in anything other than long-only stocks or bonds. This could encompass hedge fund strategies, which are normally employed in unconstrained structures, real assets, nontraditional bonds, currencies and complex ETF strategies such as inverse and leveraged ETFs.

In the past, alternative investments were primarily offered in a limited partnership (LP) structure. This structure and others can be exempt from registration with the SEC, allowing maximum flexibility in terms of strategies, leverage, liquidity, concentration and redemptions. Many LPs offer little or no liquidity for periods of months or years to match the illiquidity of the underlying assets. LPs typically incentivize managers with high fees to attract top talent, the most common being the “2 and 20” fee structure (2 percent of the fund’s assets, plus 20 percent of its gains).

Liquid alternatives are funds registered under the Investment Company Act of 1940 (’40 Act), which subjects them to greater restrictions than unconstrained funds, including limits on leverage and illiquid investments, diversification requirements, daily pricing, fees, and redeemability of shares. Unfortunately, this also gives the appearance they may be suitable for most investors.

COMPLEXITY

It’s critical for investors, advisers and broker/dealers to understand that regulators view these products as complex regardless of the liquidity and other benefits. One needs only to look at the definition of liquid alternatives through the eyes of FINRA and the SEC to understand this perspective.

Liquid alts as defined by the SEC — an alternative fund is understood to be a fund whose primary investment strategy falls into one or more of the following buckets:

• Nontraditional asset classes (such as

currencies)

• Nontraditional strategies (such as long/short equity positions)
• Illiquid assets (such as private debt)

If a fund meets any of these criteria, it may be considered a liquid alternative.

Liquid alts as defined by FINRA — according to an Investor Alert issued in 2013 and reissued by the SEC in 2017, FINRA defines liquid alternatives as those that are:

• Publicly offered
• SEC-registered
• Hold more nontraditional investments
• Employ complex trading strategies compared to traditional mutual funds

Until recently, regulators were less clear about whether they considered these products complex or required any heightened due diligence or supervisory requirements. However, over the past few years, there has been an uptick in regulatory activity around liquid alternatives.

• In June 2013, FINRA issued an Investor Alert, Alternative Funds Are Not Your Typical Mutual Funds. This alert was reissued by the SEC in February 2017. The alert states, “Investors considering alternative mutual funds should be aware of their unique characteristics and risks. Before investing, an investor should consider the fund’s investment structure, strategy risk factors, investment objectives, operating expenses, fund manager experience and performance history.”
• In 2014, the OCIE began a “concentrated review” of liquid alternatives. Bowden states, “The use of hard-to-value and/or illiquid securities in an open-end mutual fund, which requires daily valuation and offers daily liquidity, is fraught with risk.”
• In September 2014, Norm Champ, the director of the division of investment management for the SEC, stated, “alternative mutual funds present heightened risks.”
• At the SIFMA Complex Products Forum in October 2014, Champ stated that he “cannot emphasize enough the importance of ensuring retail investors have the information they need to make informed investment decisions, especially with respect to alternative mutual funds and other complex products.”
• In 2017, FINRA introduced an alternative mutual funds e-learning course in which participants are “presented with scenarios designed to emphasize the complexity of alternative mutual funds and the importance of performing a thorough suitability analysis when recommending these products.”

WHY COMPLEXITY MATTERS

The regulators have provided clear guidance on investment structures they consider complex. If the trend continues toward heightened scrutiny of liquid alternatives, one may want to veer on the side of safety in understanding, supervising and training on these funds prior to offering them to investors.

• FINRA’s Notice to Members in March 2003 provides guidance on obligations for members when selling hedge funds to include supervising associated persons selling hedge funds and training associated persons regarding the features, risks and suitability of hedge funds.
• FINRA’s Regulatory Notice in September 2009 reminds member firms of their requirement to “have reasonable grounds to believe that all material facts are adequately disclosed and provide a basis for evaluating a program … including the financial stability and experience of the sponsor and the program’s risk factors, as well as the amount and composition of dividend distributions.”
• FINRA’s Regulatory Notice in October 2010 provides clear guidance on the due diligence requirements for Regulation D private offerings, reminding members they have an obligation to conduct a reasonable investigation of the issuer and the securities.
• FINRA’s Regulatory Notice from March 2012 provides guidance to firms about the heightened supervision requirement for complex products, including strategies with novel, complicated or intricate derivative-like features, such as structured notes, inverse or leveraged ETFs, hedge funds and securitized products.
• Former FINRA CEO Richard Ketchum stated in a presentation at the SIFMA Complex Products Forum in 2012 that complex products merit heightened supervision.
• FINRA’s 2016 Investor Alert, Non-Traded REITs – Perform a Careful Review Before Investing (2016) suggests performing a careful review of a nontraded REIT before investing.

THE UNIVERSE OF LIQUID ALT FUNDS

With a broad definition and a potentially limitless universe of funds that may fall into the “anything other than long-only stocks and bonds” category, the following may help narrow the liquid alternatives universe:

• Morningstar’s alternatives category —the SEC and FINRA often refer to the Morningstar alternatives category when issuing alerts or comments regarding liquid alternatives.
• Closed-end funds (including interval funds) — these structures are regulated by the ’40 Act. However, they have fewer restrictions on the amount of illiquid assets they can hold and are often considered the most flexible registered fund structure.
• Nontraditional ETFs including leveraged, inverse and commodity-linked ETFs — FINRA issued Regulatory Notice 09-31 along with an accompanying Investor Alert in 2009 to remind members of their sales practice obligations relating to leveraged and inverse ETFs. Additionally, FINRA Regulatory Notice 10-51 addresses sales and training practices for broker/dealers selling commodity futures-linked securities, including ETFs.

UNDERSTANDING LIQUID ALTERNATIVES

There is significant variation in the types of liquid alternatives funds and countless investment strategies that may be used. It is critical for investors and advisers to understand the nuances of the strategies as well as how they perform in different market scenarios to make appropriate portfolio decisions. Many investors look to implement alternative investment strategies when markets have already declined. While there is no ideal time to add alternative investments to a portfolio, a more appropriate time may be when markets have appreciated and there is potentially more downside risk. This is a tough discussion to have with clients and can be especially difficult if the decision to add alternatives is followed by an extended period of equity outperformance. Some of this difficulty can be alleviated by setting appropriate performance expectations prior to using liquid alternatives.

In its 2013 Investor Alert, Alternative Funds Are Not Your Typical Mutual Funds, FINRA outlined several characteristics investors should consider before investing in liquid alternatives. Prior to implementing liquid alternatives, one would want to understand these factors in order to properly set performance expectations:

• Investment strategy — how will the alternative investment manager look to capture returns?
• Performance expectations — what are the expectations for returns during various market conditions?
• Strategy risks — what primary (and secondary) risks should investors be aware of?
• Portfolio application — when should a strategy be used in a portfolio? The primary portfolio applications for liquid alternatives include equity diversification, fixed-income diversification, overall portfolio diversification, risk reduction and inflation hedge.

FINRA also states in its Investor Alert that an investor should understand the “unique characteristics and risks” of a fund, which would require one to review that fund’s prospectus and other public offering documents.

COMMON RISK

While each liquid alternatives strategy has its own risks based on the type of strategy used and the underlying investments, there are common risks among the liquid alternatives universe. Investors should be aware of these risks and check each fund’s prospectus to determine if a specific fund is exposed to these and/or other types of risks.

SUITABILITY AND ACTION STEPS FOR LIQUID ALTS

Considering the regulators may view liquid alternatives as complex, the following steps should be taken to help your business comply when using liquid alternatives.

• Review the characteristics of each fund FINRA suggested in its Investor Alert including the fund’s investment structure, strategy risk factors, investment objectives, operating expenses, fund manager and performance history.
• Conduct a review of the fees and expenses of a fund.
• Review performance during different types of market conditions. Look at up/down capture, bear/bull market performance, and performance during periods of volatility.
• Understand the fund’s track record. Determine whether a fund is using its predecessor hedge fund track record or its mutual fund track record only.
• Read through the prospectus and search for potential risks.
• Conduct background checks and financial analysis of sponsor/manager firms. If you are unable to do this, ensure someone is doing this on your behalf (e.g., home office personnel).
• Ensure a training process is in place for registered persons and their supervisors.
• Document everything on this list. If regulators cannot see what you have done to review liquid alternatives, then it will be as if it never happened. Put a folder together (physical and/or electronic) to track everything you review.

CONCLUSION

The liquid alternatives market has grown substantially during the past decade, along with increased regulatory scrutiny. In the past, regulators have focused primarily on private placements, nontraded products, and certain ETFs as complex, suggesting heightened due diligence, supervision, training and ongoing monitoring at the fund level. Guidance also suggests documentation of the process. With increased regulatory focus on the complexities of liquid alternatives, as well as a recent example of the potential risk of alternative strategies in a ’40 Act fund, it may be prudent to implement written policies and procedures for liquid alternatives similar to what is in place for other complex products.

Laura Sexton is senior director of program management at AI Insight. This article is excerpted from a white paper on the subject, which can be read in its entirety at this link: https://bit.ly/2ylNukd