Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Liquid Alternative Funds: Hedge Funds for the Rest of Us?

Have you ever heard a pitch like this?  “We’ve got a fund that incorporates the best of both worlds: Hedge fund like strategies and return potentials without the high fees and loss of liquidity!”  Well, maybe.  Let’s take a look at these vehicles — liquid alternative funds – alternative strategies in mutual fund form, that attempt to add value outside of traditional long-only investment strategies. It appears that this instrument will give all investors easy and affordable access to an asset class that was previously reserved for the most affluent.  But are these alternative funds as effective or advantageous as advertised?  What do the data tell us so far about the efficacy and performance of this style of fund?

Liquid Alts

Unfortunately, alternative investments do not have a universally accepted definition, and the term alternatives is often used as a catch-all to describe any investment product outside of standard investments in publicly listed stocks and bonds.  In addition to hedge funds and non-traditional mutual funds, this broad definition could include asset classes such as real estate, commodities, private equity, and timberland.  Here our focus is exclusively on non-traditional equity strategies, which are packaged as mutual funds.  Among these strategies are long/short and market neutral funds, approaches that aim to achieve risk-adjusted returns through superior security selection (selecting stocks that will outperform and those that will underperform), and event driven funds which seek to gain from specific market events such as company mergers or restructurings.  Some multi-strategy funds combine strategy types, including those mentioned as well as others, often attempting to outperform through manager selection.

The Pitch

Alternative strategies have varying objectives.  Some attempt to generate higher returns than similar equity benchmarks, while others opt for absolute return strategies, with the goal of providing positive returns in all market environments.  In the past, these strategies were available only through hedge funds, which are far from ideal for most investors. The pool of eligible investors in hedge funds is severely limited. To be eligible, an investor must be accredited, meaning they have a net worth of at least $1,000,000, or an income of at least $200,000 for each of the two previous years (or $300,000 for a married couple).  That cuts out a lot of investors.  Even if an investor is accredited, they also may face high minimum investments, often $250,000 or $500,000.

Once invested, hedge funds typically allow only quarterly redemptions, and some also include gate provisions, under which withdrawals might be limited or even stopped entirely during turbulent market periods.  Hedge fund holdings do not have to be reported daily, often making their investment strategies opaque and inscrutable to all but the fund managers.  Finally, hedge funds are notorious for their high fees, generally charging 2% of assets under management and 20% of profits annually.

All That Glitters…

Compared to the drawbacks of traditional hedge funds, alternative strategies in mutual fund form would appear vastly superior for retail investors.  Unfortunately, as with most things investment related, there are no free lunches.  Liquid alternative funds have consistently underperformed similar hedge fund strategies, even net of fees.  For example, the average market neutral hedge fund had a 10-year return of 2.80% annually, while the average liquid alternative mutual fund in the same category returned 1.87% per year over that period.1  Similarly, the average multi-manager hedge fund outperformed its average mutual fund peer 3.08% to 2.64% over the past decade.

There are several plausible explanations for this significant underperformance.  First, many of the downsides of investing in hedge funds from an investor’s perspective are exactly those factors that allow the hedge funds to add their value.  The higher fees allow for much higher levels of compensation for fund managers, thus attracting the best available research and portfolio management talent.  Moreover, the constraints placed on mutual funds conversely allow hedge fund managers more freedom.  They can operate with fewer restrictions on leverage, short selling, and other more innovative aspects of investment strategy.  Hedge fund restrictions eliminate the need to liquidate during volatile markets to assuage investors panic.  Perhaps the largest benefit to hedge fund managers is the absence of transparency.  Their proprietary trading strategies are not exposed by daily NAV reporting required in public markets and thus cannot be replicated by other market experts, and their “edge” need not be immediately narrowed by competition.

So if liquid alternative funds are only poor substitutes at best to hedge funds, does this put the retail investor at a huge disadvantage? Not necessarily.  While the mystery and exclusivity surrounding hedge funds makes them an attractive investment, it is not clear that on average they truly add value over simple long-only investment strategies.2  Although lacking the glamour, a 60/40 mix of the S&P 500 index and the Barclays Aggregate US Bond index has outperformed a fund-weighted composite of hedge fund returns by 1.19% annually over the past 10 years.  In investing, as in many aspects of life, the simple option is often the best.

References
1. Hedge fund data provided by hedgefundresearch.com, mutual fund and index data provided by Morningstar, as of 4/30/14.
2. See, for example: Dichev, I. and G. Yu (2011), Higher risk, lower returns: What Hedge Fund Investors Really Earn, Journal of Financial Economics 100, 248-263

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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