Editor's note: This is the first in a three-part series on liquid vs. traditional hedge fund/alternative investing, examining how clients can access strategies and managers through different structures. The second piece will explore what strategies are the best fit for a client’s portfolio vis-à-vis the liquid and traditional structure. The last piece will focus on manager selection, highlighting how to access the right manager.
Hedge fund strategies delivered through a mutual fund structure have risen in popularity. Still, advisors need to consider whether their clients can get access to the best strategies and managers through these liquid vehicles versus the traditional structures for alternative strategies, such as L.P. investments or closed-end, tender offer funds.
Hedge funds and other forms of alternative investments can play a critical role in the portfolios of investors. When delivering attractive risk-adjusted returns with low correlation to broader multi-asset class portfolios, alternatives can provide a valuable form of diversification.
In response to certain investor concerns regarding traditional hedge fund structures (i.e. liquidity constraints), the investment industry over the past decade has seen a proliferation of “liquid alternatives”—hedge fund strategies delivered through mutual fund vehicles. While liquid alternatives may seem attractive at first glance, it's important to understand the limitations inherent in these vehicles.
When recommending investments in hedge funds and other forms of alternative strategies, two of the most important decisions are:
- Which strategies are the best fit for the client’s portfolio?
- Within those strategies, which managers are able to deliver the most attractive risk-adjusted returns?
We believe that alternative investments offer investors the opportunity to access differentiated return streams and risk profiles that can work in tandem with various long-only strategies in a portfolio. While the world certainly does not need 12,000 hedge funds (many of which, in our view, are run by managers with little-to-no skill), we do believe that the best active management talent gravitates to the traditional hedge fund space due to the unconstrained nature of the investment structure. As a result of regulations and structural considerations, trying to invest in alternatives via liquid mutual funds can result in a narrower subset of possible investment strategies and negative selection bias that limits access to the highest-quality managers. Before investing in these strategies, ask yourself if the benefit of daily liquidity outweighs the benefit of a full suite of strategies and managers offered by traditional, albeit less liquid, alternative investment structures.
To address the confusion that has arisen about liquid and traditional hedge fund vehicles, this series will examine these questions and provide guidelines to help advisors determine how to access the right strategies and managers for their clients’ alternative investments.
Kenneth Meister is the President and Chief Operating Officer for Evanston Capital Management.