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Drowning in Liquid Alts

Goldman Sachs recognizes 298 funds as true liquid alts, spread out over five broad categories

Liquid alternative funds, which seek to replicate hedge fund strategies in registered mutual fund structures, should play a substantial role in most client portfolios, argued a team of fund strategists at Schwab’s annual IMPACT conference. Used appropriately, they reduce the risk of an investor’s overall portfolio while having a minimal effect on its performance.

Yet many of the financial advisors who use them are “doing it all wrong,” said Nadia Papagiannis, the Director of Alternative Investment Strategy with Goldman Sachs Asset Management, which has made a big push into liquid alternative funds. “Every survey out there shows advisors want liquid alternatives for diversification.” Yet most of the money is going into a single type of strategy: long-short equity, which seeks to provide some cushion to falling markets by shorting a select group of stocks alongside a traditional portfolio.

Even worse, one long-short fund, MainStay Marketfield, has absorbed a full 25 percent of the total $58 billion invested in liquid alts of all types since 2011. Traditionally one of the best funds in its class, fortunes for MainStay Marketfield turned this year and its performance is now in the bottom five percent of all long-short mutual funds, according to Morningstar data. It’s trailing the category by 12 percent.

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That suggests advisors are guilty of performance chasing and not really diversifying their portfolios and adjusting the risk profile, the panelists said. The problem is data overload from the proliferation of funds. The number has exploded from a handful a decade ago to hundreds today, Papagiannis said. “Advisors don’t know how to determine whether a fund is doing what it says it will do." Morningstar, for instance, classifies 462 funds as liquid alternatives spread out over 14 different categories.

Papagiannis (who used to research liquid alternatives at Morningstar) and a team at Goldman Sachs screened that universe through their own filters, starting with a definition: Liquid alts must demonstrate “differentiated returns and lower risk.” That alone reduced the number of funds by half, she said.

They then matched those up against existing hedge funds whose strategies they mimic. On the hedge fund side, there is 20 years of performance data to pull from, she said, giving advisors a better idea of how the strategies hold up in different environments.

In the end, Goldman Sachs recognizes 298 funds as true liquid alts, spread out over five broad categories: Long-short funds; event driven funds, which seek to profit from corporate events like mergers or bankruptcies; relative value funds, which trade on the gaps in prices between similar securities; tactical trading funds, which include managed futures; and multi-strategy funds, which employ two or more strategies in a single fund. Left out of Goldman Sachs’ universe are option income funds, tactical shorting and leveraged indexed funds.

By looking at the funds against hedge funds that use the same strategies, Papagiannis could benchmark the strategies to determine which does better in a liquid alt format and which does better in the traditional private placement approach. They found that the mutual fund format was the better approach for long-short equities and for tactical trading. Hedge funds are the better wrapper for event-driven or relative value strategies. That’s largely because the managers of those hedge funds can invest in illiquid securities and use higher levels of leverage than are allowed in mutual funds. Papagiannis suggests advisors may want to look at investing in hedge funds themselves to get at those strategies, if possible, or access them through a multi-strategy fund.

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