Liquid alternatives fail to deliver on promise of returns

By Chris Flood. This article originally appeared on the Financial Times website, on September 14th, 2014

Mutual funds that employ hedge fund strategies, known as liquid alternatives, are arguably the hottest investment trend of the moment, attracting interest from a growing number of investors as well as that of regulators.

But most liquid alternatives have not created any value for investors and have failed to deliver on their promise to provide positive returns regardless of market conditions, according to research by academics at the University of Alabama.

The research, which examined the performance of 318 alternative mutual funds between January 2008 and December 2011, found that the performance was even worse during the financial crisis.

Investors, the academics say, would have been better off using index funds tracking the S&P 500 than equity liquid alternatives over the entire four year period.

“Investors should be wary of having unrealistic expectations of the performance and diversification benefits of these alternative mutual funds,” says professor Robert McLeod.

The warning, however, comes as assets in US liquid alternatives pass the $300bn mark, while assets in alternative Ucits have reached some €236bn ($306bn).

McKinsey, the consultancy, says up to half of net new revenues from US retail investors could flow into liquid alternatives over the next five years, driven by greater adoption by registered investment advisers and the large brokers (wirehouses).

Liquid alternatives proliferated after the repeal in September 1997 of the so-called “short-short” rule that heavily taxed mutual fund managers if they earned more than 30 per cent of their gross income from sales of securities held for less than three months.

Deutsche Bank forecasts that liquid alternatives will attract $49bn of new cash over the next 12 months, up from $34bn over the past year, with inflows accelerating from private banks, wealth managers, funds of funds and institutional asset managers.

Indeed, almost three quarters of investors that use alternative Ucits and nearly two-thirds of those investing in US liquid alternatives plan to increase their allocations over the next 12 months, according to Deutsche, which surveyed 212 investors and 86 hedge fund managers.

But Deutsche’s survey also points to performance issues. It found that 31 per cent of the US managers it surveyed held products that underperformed their corresponding hedge fund strategy. This was still an improvement on the previous year when that number was 50 per cent.

“Poor performance is cited as the primary challenge to investing in liquid alternatives for 11 per cent of responding investors,” says Deutsche.

Onur Erzan, a director at McKinsey, says liquid alternatives are typically more complex than traditional mutual funds and require investors to perform thorough due diligence so they properly understand how these products match their risk appetite and asset allocation requirements.

Constraints on leverage and liquidity can hinder their performance compared with full blooded hedge funds.

A 2013 study by Cliffwater, the consultancy, found that investor returns on average were reduced by around 1 per cent a year for the better liquidity offered by liquid alternatives. Cliffwater said it could not judge if the performance shortfall was a “fair exchange” for the improved liquidity offered by alternative mutual funds.

Josh Charlson, director of research for alternative strategies at Morningstar, says it can be problematic for investors to make “apples to apples” performance comparisons. “There is a clear trade off in giving up some of the illiquidity premium in hedge funds but gaining through the lower fee structures of liquid alternatives,” he says.

Fees are also generally higher for liquid alternatives than for traditional mutual funds, a point that Vanguard, the low-cost fund company, has been at pains to emphasise.

Vanguard also found that allocating 10 per cent of a global stock and bond portfolio to a range of liquid alternatives between 2007 and 2013 resulted in lower or unimproved Sharpe ratios (risk adjusted returns), an outcome that would not meaningfully improve an investor’s spending power.

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