Reprinted courtesy of the National Post
by Tom Bradley

There’s a new kid in town. It’s a category of funds called ‘liquid alts’ (as in, alternatives). They’re a cross between a hedge fund and mutual fund. They use strategies like short selling, arbitrage and leverage, and yet have the low minimums, daily liquidity and regulatory oversight investors are used to.

I should clarify how the word ‘alternative’ is being used here. Liquid alts refer to ‘alternative strategies’ used to manage stocks and bonds, which is different from ‘alternative asset classes’ such as infrastructure, private equity, direct lending and real estate.

What are they?

Liquid alt funds are not shooting for the stars. Most are designed to smooth out portfolio returns by having a low correlation to stocks. They’re pursuing the holy grail — equity-like returns with bond-like volatility.

At this stage, there’s more supply (37 funds from 15 providers) than demand, but it’s early days.

It’s only been a year since new regulations allowed liquid alts to exist, and they’re emerging at a time when investors are abandoning bonds (or want to), worrying about stocks and feeling less certain about real estate.

Of the 37, some are focused on fixed income, others are long/short equity and a few use multiple strategies.

The long and short of it

Lofty goals require more exotic strategies, one of which is long/short equity. This is where the manager holds stocks (long) she likes and sells short ones she believes are going down. The payoff comes when the longs do better than the shorts.

In general, managers are looking for pockets in the bond and stock market that are mispriced.

They especially like dislocations that are too small for the big institutions to bother with.

A hedge fund I saw recently was founded on the basis that corporate bonds overcompensate lenders (via higher yields) for default risk. His strategy, which is used in many liquid alt funds, is to capture this generous compensation by buying corporate bonds using money raised from selling government bonds short. The interest paid on the government bonds is more than offset by the higher coupon on the corporate holdings. As long as there are no corporate defaults, the strategy works well.

Octane needed

For these and other strategies to produce attractive returns, an extra boost is needed. That’s where leverage comes in (yes, they borrow to invest).

Instead of looking for high potential opportunities that have uncertain outcomes (like an equity fund), these funds choose more predictable, lower-return situations and then borrow money to replicate the strategy multiple times. This dials up the return potential.

Alternative to what?

Do liquid alts fit into your portfolio? The fund brochures suggest they can replace equities to reduce volatility and price declines, be a substitute for fixed income to enhance returns (albeit with more volatility), or some combination of the two.

With all approaches, it’s important to have appropriate expectations. These funds can help your portfolio when stocks and bonds are behaving normally, which is a majority of the time. In rare circumstances when stocks are falling, they’re likely to go down less (low correlation does not mean no correlation) or not at all. But when stocks are on a roll, these funds will lag behind.

No free lunch

To own liquid alts, you require a high level of investment knowledge, extra research and a well-informed advisor. And you should keep the following points in mind:

The pedigree of the manager is important. Compared to traditional funds, returns are more dependent on their decisions and less on the direction of the market.

Complexity means more unexpected outcomes. The marketing materials outline what success looks like, but you also need to understand when the funds will perform poorly and why.

Advanced techniques come at a price. Of the 37 funds, 27 have performance fees — i.e. the manager gets a portion of the profits. There are two things to watch for here. First, there should be a ‘hurdle rate,’ or return that must be achieved before the manager starts sharing in the profits. And second, don’t invest without a ‘high water mark,’ which means the fund must make up for any losses before it’s eligible for performance fees.

And equity-like returns come with equity-like risk. With liquid alts, risk takes different forms (loan defaults; volatile yields and credit spreads; tighter borrowing terms; and illiquidity) and shows up at different times, but there’s no free lunch. The strategies are ingenious, but there are lots of moving parts, the landscape is competitive, and the fees are high.