Alternative investments are generally considered illiquid investments as they cannot be traded actively in the marketplace at a readily known price. Because of this, liquid alternatives can be a tempting investment solution for some financial advisors that have placed a renewed emphasis on downside protection and the inclusion of non-correlated assets within a client’s strategic asset allocation mix.

A quick definition from Investopedia states that Liquid Alternatives “are mutual funds or exchange-traded funds (ETFs) that aim to provide investors with diversification and downside protection through exposure to alternative investment strategies.”

In an effort to diversify an investment portfolio, investors may be swayed into using liquid alternatives as a method to keep costs low and maintain adequate liquidity. Some have increasingly turned to liquid alternatives as a means to expand their investment universe while preserving a level of portfolio liquidity with which they have historically been comfortable.

By and large, liquid alternatives have been marketed as a cost-effective means of extracting both outsized absolute returns and attractive risk-adjusted returns in the marketplace. However, the ability to capture “alpha” in the market is exceedingly difficult and opportunities are sometimes exploited by the most sophisticated investors.

Another tradeoff of liquid alternatives for offering daily liquidity is certain limitations imposed by liquidity demands. For example, in order to meet their daily liquidity requirements, liquid alternatives are forced to severely limit the range of investment strategies they can pursue and are bound to the more liquid end of the hedge fund strategy spectrum. Therefore, a majority of liquid alternatives simply employ long/short equity, global macro, and/or managed futures strategies.

In comparison, the hedge fund industry consists of a much larger universe of strategies with some of the more compelling investment approaches unavailable in a liquid alternative fund structure. For example, distressed credit funds are currently unavailable in liquid alternative funds due to these liquidity constraints.

Source: Investopedia

While liquid alternatives undoubtedly serve the liquidity-conscious investor who may not be able to access hedge funds directly, hedge funds often outperform their liquid alternative counterparts by a number of different measures.

Morningstar is an investment research firm that is highly recognized for its mutual fund rating system. The firm does not mince any words when it comes to liquid alternatives’ performance. “We estimate investors collectively paid about $21 billion in fees to liquid alternative funds between March 2009 and June 2020 while reaping only $20 billion in return.”

Morningstar continues, “As the preceding exhibit shows, had it not been for the 2015-16 correction, the late 2018 drop, and the early 2020’s bear market, liquid alternatives would have been able to outpace their fees. In March 2020, for example, the wealth created by liquid alternative funds fell by $8 billion, or more than one-third of the $22 billion they had created to that point.”

Morningstar states that had it not been for adverse events, these funds would have at least earned their fees.

One of the reasons for investing in alternatives is to seek excess risk-adjusted returns compared to traditional asset classes. These funds attempt to do so by diversifying one’s portfolio from the volatility of the market. However, if Liquid Alternatives are crashing alongside the market, while also underperforming when the market is moving higher, then the purpose of investing in these instruments is defeated.

Sources:
Morningstar, April 2020. “Where Are the Liquid Alternative Shareholders’ Yachts?” ;
The Wall Street Journal, October 2017. “The Morningstar Mirage.”

The investment consultant, Wilshire, created a buffet of liquid alternative indices to help track performance.

As the research shows, none of the indices below even had returns reaching 5% per annum over a 5 or 10-year period.

Combining assets with varying correlations in a diversified portfolio can increase risk-adjusted returns. Alternatively, an active manager can also strategically or tactically reweight portfolio holdings to express a market view. However, as the earlier chart from Morningstar showed, these liquid alternatives have not performed particularly well during market drawdowns.

Instant liquidity can be tempting. The ability to turnover a portfolio daily while providing access to differentiated sources of returns has been a primary contributor to the growth in the liquid alternatives industry.

However, while liquid alternatives undoubtedly serve the liquidity-conscious investor who may not be able to access hedge funds directly, hedge funds often outperform their liquid alternative counterparts by a number of different measures.

Industry experts such as Morningstar and Wilshire both illustrate some of the potential shortcomings of this broader asset class.

For those who are not constrained by liquidity pressures, institutional-quality hedge funds may possess a greater risk/reward payoff than the leading liquid alternative funds can offer.