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A Hedge Fund Manager’s View on Liquid Alternatives

There’s something amiss in the liquid alts space.

After years of stellar growth, adoption of liquid alternatives at wirehouses ground to a halt last year, according to a recent study by the Money Management Institute and Dover Financial Research called Distribution of Alternative Investments Through Wirehouses (2016). Consequently, despite growing risks in 60/40 portfolios, most retail investors are significantly under-invested relative to target allocations. On top of this, some big players that were early adopters of liquid alternatives are rethinking that move strategically.

New York Life acquired the Marketfield Fund (MFLDX) in October 2012, and raised over $20 billion in AUM through 2013. But investors withdrew 90 percent of those assets by the end of last year, and the insurer subsequently sold it back to Marketfield Asset Management.

With great fanfare, Fidelity seeded two multi-manager funds (ARDNX and BXMMX) in 2012-2013, invested more than $2.5 billion over the next two years, then suddenly reversed course and pulled out in 2015-2016.

Virtus launched three multi-manager mutual funds (VATAX, VSAIX and VAICX) in partnership with institutional consulting firm Cliffwater, only to quietly shut them all down a few years later.

“Generation one” of liquid alts had three major issues:

1. Hype versus reality. Take multi-manager mutual funds. They were pitched as “better than hedge funds”: You get the returns along with liquidity and lower fees. Missing was any serious discussion of how mutual fund constraints would impact strategies normally run without them. At the time, we likened it to asking a mixed-martial artist to step into a ring with a boxer but not use kicks or holds. As predicted, those constraints cut performance by hundreds of basis points. In fact, in the four years through 2015, multi-manager mutual funds returned only 2 percent per annum — half that of higher-cost hedge funds.

Quasi-alternative tactical ETF strategies also deserve honorable mention. These managers raised tens of billions of dollars on the unrealistic promise that their models would anticipate market drawdowns. Instead, they were whipsawed repeatedly by choppy markets from 2011 to 2015, lost almost all their assets and proved once again that market timing is nearly impossible.

2. Asset allocation versus returns chasing. Asset allocation is predicated on finding investments with predictable long-term performance; if an active manager can consistently outperform the bucket, all the better. For most traditional strategies, closet indexing means that even if you pick the wrong fund, you’ll still be in the ballpark. In the liquid alts space, though, returns are all over the map. Let’s return to the Marketfield fund. It outperformed the equity hedge fund index by almost 8 percent per annum through 2013; since then, it’s underperformed by over 25 percent. If it looks too good to be true, it probably is. More broadly, one in six equity long/short mutual funds has underperformed by more than 20 percent over just the past three years. In liquid alts, pick the wrong manager and you can be really, really wrong.

3. Fees. Only someone used to a 2 and 20 fee structure would consider a 3 percent expense ratio a bargain, but that’s the thinking behind multi-manager mutual funds. Remarkably, those funds paid themselves 60 cents of every dollar made in 2012-2015 — a worse ratio than for hedge funds.

Advisors and their clients are looking for proven, predictable outperformance relative to a benchmark (bucket), low fees and a simple structure.

With that in mind, here are a few recommendations:

First, focus on (realistic) outcomes. Too many alts products are sold on recent returns or how the gears work, when what we really should care about is how the product can improve risk-adjusted returns over time. The John Hancock Global Absolute Return Strategies Fund (JHAIX) and the Putnam Absolute Return 500 Fund (PJMDX) have a clear and simple pitch: LIBOR plus 5 percent with low (0.2) equity beta. Equity hedge strategies can deliver equity-like returns with bond-like risk, provided you hold them over a full market cycle. But expect them to underperform in a raging bull market. CTAs or managed futures can return LIBOR plus 4 percent with essentially no equity beta. Those all have a place in a prudently diversified portfolio.

Second, fees matter. One of the issues with hedge funds is that they have to make 10 percent to deliver 6 percent to investors; that’s much, much harder than hitting 7 percent to get 6 percent. Risk isn’t necessarily linear, especially when you’re trying to generate returns without loading up on more equity beta. Look for low-cost products because, over long periods of time, fee reduction truly is the purest form of alpha.

Finally, link the product choice to the asset allocation objective. Today, the industry lacks good “sector” products which minimize individual manager risk. There’s a reason pension funds invest in 25 or more hedge funds; they’re trying to create something that looks like the whole bucket. In liquid alts land, too many allocators pick a single manager and miss the bucket by a wide margin.

Based on those three criteria, here’s a prediction: We’ll see a resurgence of hedge fund replication. Why? Early skeptics had hedge fund franchises to protect. Today, however, institutional investors acknowledge that simple replication strategies have consistently outperformed actual hedge funds over the past decade (in some cases, by 100 bps or more per annum with much lower drawdowns in 2008). Importantly, the strategies can work seamlessly within 40 Act funds so performance doesn’t suffer. In addition, all-in expenses should be very low, e.g., no short interest costs or acquired fund expenses for futures-based portfolios. Plus you also get “sector-like” predictability, since replication is based on large pools of funds, not the hot dot. In this particular case, there’s a strong argument that imitation truly is better than the real thing. 

Andrew Beer is the Managing Partner and Co-Portfolio Manager at Beachhead Capital Management.

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