Liquid Alternatives: Alternative Enough?

Fake Alternatives?

September 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Liquid alternatives offer hedge fund strategies in mutual fund format
  • The correlations to the S&P 500 have been high, even of market neutral funds
  • Diversification benefits have therefore been limited

DISRUPTING THE HEDGE FUND INDUSTRY

Liquid alternatives have been heralded as hedge funds for Main Street as these investment vehicles offer typical hedge fund strategies in mutual fund format with daily liquidity. While they have higher management fees than plain vanilla mutual funds, liquid alternatives charge less than hedge funds and don’t charge performance fees.

Given their lower fees and greater transparency, liquid alternatives were expected to disrupt the hedge fund industry in much the same way that exchange-traded funds (ETFs) disrupted the mutual fund space. However, ETFs have enjoyed continuous growth in assets under management (AUM), while liquid alternatives have stalled at around $350 billion in AUM since 2013, according to data from Wilshire.

Hedge funds have experienced a similar stall, hovering at around $3 trillion in AUM over the last five years. Given strong equity markets, investors likely were less inclined to hedge their portfolios. Moreover, hedge funds also failed to generate meaningful alpha (read Hedge Fund Factor Exposure & Alternatives).

So how do liquid alternatives perform from a risk-and-return perspective in the context of an equity portfolio, particularly the three largest groups in the liquid alternative mutual fund space — absolute return, long-short, and market-neutral strategies? (try Finominal’s Security Analyzer for ETF or mutual fund analysis)

LIQUID ALTERNATIVES PERFORMANCE

Long-short and long-only strategies are not comparable, so hedge funds and liquid alternatives shouldn’t be benchmarked to the S&P 500. But the S&P 500 can illustrate the different phases of the market cycle.

The chart below highlights the similarity between the S&P 500 and an equal-weighted index of long-short liquid alternative mutual funds. This is to b