What on Earth are “Liquid Alternatives”?

Scarcely a day goes by that I don’t receive a call or at least two emails from somebody trying to sell me a Liquid Alternative mutual fund. Thankfully, only one of my clients has come to me saying “I’ve GOT to have some of these.” So what are these things and why might you want to own them?

liquid-alternative-mutual-funds-600x372Sometimes called ‘hedge funds for the masses,’ a liquid alternative fund is basically a mutual fund that uses a hedge fund-like strategy to select its investments. These might include strategies like:

  • Market neutral or long-short (buying some stocks while selling short or betting against others at the same time);
  • Managed futures strategies, in which the fund manager bets on the future prices of commodities;
  • Unconstrained bond funds, where managers can buy any kind of bond of almost any maturity, or even short (bet against) bonds.

The basic goal is to diversify your portfolio. In a market where both stocks and bonds seem unlikely to perform well in the future, then other types of investments or strategies can be appealing.

Liquid alternative mutual funds can have exotic sounding names like “Event Driven Arbitrage” or “Smart Beta” and often come with a compelling sales pitch. But there are some important factors to remember when considering these kinds of strategies.

Alternative funds are expensive. According to Morningstar, the average Multialternative mutual fund carries a cost of 2.03% per year. With an average 10 year return (through 5/31/2015) of 3.7%, you’re paying a lot for that diversification, and there are huge differences from one fund to the next. When you consider the S&P 500 Index of large company stocks earned 8.1% per year over the same period, and the Barclay’s US Aggregate Bond Index (representing the total bond market) averaged 4.6%, a plain old 60/40 stock bond mix looks pretty good.

Most alternative funds are new. Which brings up my second point. There are only 22 funds in that 10 year history, compared to 506 with a 3 month track record. The vast majority of these funds are brand new and haven’t really been tested through thick and thin.

The strategies are opaque. A lot of the strategies will sound attractive, but at the end of the day, many of these liquid alternative mutual funds end up acting like the stocks or bonds they’re meant to be avoiding—but with much higher fees.

Tax treatments for liquid alternatives can be different, too. One thing that you have to be careful about with alternative strategies is that they often involve a lot of options or futures contracts. Or frequent trading. This isn’t inherently bad, but these have the potential to create large tax bills that don’t show up in the fund’s performance numbers.

Hedge fund strategies may not work in a mutual fund. Hedge funds have been around for a long time. They have been used by the wealthiest investors to make long-term investments that might be illiquid (hard to get out of quickly) or very complicated. They often involve million dollar minimums, can use massive amounts of leverage and often lock up investments for several years. Mutual funds are much more limited in how much leverage they can use or what they can buy, so these strategies won’t translate smoothly.

Perhaps the most important issue regarding liquid alternative mutual funds is behavioral. Investors want diversification when things are falling apart, but when the stock market is going straight up, watching a fund tick away with a steady 4% return can get really painful.

One final point. What does it tell you that CALPERS, the largest Pension fund in the United States (with a larger professional investment management staff than many investment companies) announced in 2014 that they were getting rid of most of their hedge funds? Their stated rationale is the complexity and cost of these exotic strategies.

If you can find a low cost liquid alternative that truly diversifies the risks in your portfolio, and you can maintain a disciplined allocation to it for the long-term, then some of these things might be worth looking into. We do work with a couple of liquid alternative mutual funds, and have analyzed quite a few others. If you have any questions about these investments, or how they fit into your portfolio, please contact our office.

About Rick Brooks

Rick Brooks, CFA®, CFP® is a partner of Blankinship & Foster LLC and is the firm’s Chief Investment Officer. He is a lead advisor, counseling clients on all aspects of personal financial management. Rick serves on several boards. He is the Chairman of the Board of Girl Scouts San Diego, and also chairs the San Diego Foundation’s Professional Advisor Council. Rick and his family live in Mission Hills. Rick enjoys spending time with his family, theater, cooking, skiing, gaming and reading.

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