In the last few years, touch-screen soda fountains have become increasingly common in fast-food restaurants, and these machines offer an impressive array of choices to thirsty customers. Still, while it's possible to serve up diet cherry vanilla sparkling water or caffeine-free raspberry root beer, the flavor experience might not be exactly what you'd expect. In the same way, liquid alternatives, which attempt to expand, eliminate, or rearrange traditional types of investment risk, may not provide investors with exactly the outcomes they expect. Here are some key questions to ask before ordering up a liquid alternative exchange-traded fund (ETF) for your portfolio.
What are liquid alternatives?
The criteria used to define liquid alternatives is still extremely fluid and subject to a large dose of interpretation. Morningstar defines these products as mutual funds or ETFs that use a mix of investment strategies, securities, or techniques to provide returns that differ from conventional, long-only exposure to more familiar asset classes, such as equities or fixed income.1 Many liquid alternative funds attempt to replicate hedge fund strategies, but there are also liquid alternative ETFs pursuing strategies for which there is no hedge fund equivalent. Nevertheless, we tend to think of liquid alternatives as investment products that create a retail vehicle for the trading strategies commonly associated with hedge funds.
Because they target retail investors, liquid alternatives are typically based on the same legal structures that underpin traditional mutual funds and ETFs, rather than aligning with the private fund rules that normally apply to hedge funds. As a result, most liquid alternative ETFs are registered under the Investment Company Act of 1940, but there are also liquid alternative ETFs based on partnership or grantor trust structures.2 This allows liquid alternative ETFs to attract investors of all sizes, not just those with "accredited" or "qualified" status, as long as they meet the same regulatory standards as other public funds.
What are the advantages of liquid alternatives?
In addition to offering broader access to unconventional strategies, here are some other advantages of liquid alternatives compared to hedge funds.
- Liquidity: Unlike hedge funds, ETF issuers may not impose gated redemptions or require investors to commit to lock-up periods. Instead, liquid alternative ETFs can be purchased and sold on exchanges during normal trading hours. Although, as with any ETF, investors should watch for wide bid-ask spreads and volatile premiums/discounts in less actively traded products and products with less liquid holdings.
- Lower minimums: The minimum investment for an ETF is significantly lower than it is for a hedge fund. A single ETF share can be purchased for as little as a few dollars, while a hedge fund may have an investment minimum as high as $1 million.
- Transparency: Most ETFs are required to publish their holdings daily, which may help investors better understand what's actually inside a fund's portfolio. Hedge funds, on the other hand, have no such requirement.
- Lower fees: Liquid alternative ETFs typically have much lower fees than hedge funds. This is due in large part to the fact that performance fees are not allowed in traditional fund structures.
- Regulatory oversight: By using the same legal structures developed for traditional public funds, liquid alternatives are subject to more regulations and oversight. These include restrictions on the use of leverage and short selling, which may dampen volatility.
What are the disadvantages of liquid alternatives?
Here are a few things to consider.
- Complexity: Investors who are considering liquid alternative ETFs should be prepared to spend a considerable amount of time researching their options. Many liquid alternative strategies are complicated and can leave even professional investors scratching their heads! Be prepared to ask lots of questions, either to your financial advisor or to the ETF issuer directly. And keep in mind that past performance is not a shortcut and doesn't imply future success.
- Closure risk: Although any ETF may close (due to poor performance or lack of investor interest), Morningstar reports that the average age of alternative funds is lower, and the number of funds closed is higher.3 Investors who own shares of an ETF that has announced its closure will need to decide whether to sell before the fund delists or wait for the fund's final liquidating distribution. Additionally, these investors must recognize a gain or loss at a time they might not expect and may need to spend more time researching a replacement fund.
- Higher fees: While liquid alternatives are usually less expensive than hedge funds, they tend to be more expensive than other types of mutual funds and ETFs. Although higher fees may be justified (managing more complicated strategies often requires larger teams and more technological resources), investors should consider whether a fund's potentially higher returns might simply be eaten-up by its higher fees. According to Morningstar, in 2021 the asset-weighted average fee was 1.10% for actively managed alternative funds and 0.65% for alternative funds tracking indexes. This compares to 0.60% for all active funds and just 0.12% for all funds tracking indexes.4
- Investment Limitations: Liquid alternative ETFs registered under the Investment Company Act of 1940 face limitations on holding illiquid, short, and leveraged positions. As hedge funds do not face such limitations, there may be alternative investment strategies that liquid alternative ETFs cannot effectively implement.
- Investor gap: Finally, investors should consider whether they have the patience and temperament to endure a significant stretch of underperformance combined with bouts of short-term volatility. Morningstar reports that most investors haven't had the stomach for liquid alts as shown by the gap between time and dollar-weighted returns, which incorporate cash flows into and out of the fund to measure how the average investor performed over time.5
How can I find liquid alternative ETFs at Schwab? And where should I begin my research?
To start, use the ETF screener to identify alternative ETFs by Morningstar category. After analyzing the fund's research page on Schwab.com, locate the issuer's own website to review the fund's fact sheet, prospectus, and any other materials the issuer may provide to help explain the investment strategy. Comparing at least a few funds in the same category may help you understand the strengths and weaknesses of each one.
Use the ETF screener to identify alternative ETFs by Morningstar category.
Liquid alternative fund categories
- Alternative
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AlternativeDigital Assets
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Digital asset portfolios provide exposure to blockchain, stable coins, currency assets, smart contracts platforms, exchange assets, privacy assets, yield farming, and nonfungible tokens (NFTs), among other assets. Portfolios may gain access to digital assets through physical or derivative exposures and incorporate both long-only investments and other hedging techniques.
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AlternativeEquity Market-Neutral
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Equity market-neutral strategies attempt to profit from long and short stock selection decisions while minimizing "systematic" risk (i.e., risk inherent to the overall market, not just a specific industry or stock). They try to achieve this by matching long positions within each area against offsetting short positions.
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AlternativeEvent-Driven
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Event-driven strategies attempt to profit when security prices change in response to events such as bankruptcies, mergers and acquisitions, emergence from bankruptcy, shifts in corporate strategy, and other atypical events. Activist shareholder and distressed investment strategies also fall into this category.
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AlternativeMacro Trading
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Macro trading strategies look for investment opportunities by studying such factors as the global economy, government policies, interest rates, inflation, and market trends. These funds are not restricted by asset class and may invest across such varied assets as global equities, bonds, currencies and commodities.
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AlternativeMulti-Strategy
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Multi-strategy portfolios offer investors exposure to two or more alternative investment strategies, as defined by Morningstar's alternative category classifications. Multi-strategy funds typically aim to have low to modest sensitivity to traditional market indexes.
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AlternativeOptions Trading
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Options trading strategies use a variety of options trades, including put writing, options spreads, options-based hedged equity, and collar strategies, among others.
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AlternativeSystematic Trend
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Systematic trend strategies primarily implement trend-following, price-momentum strategies by trading long and short liquid global futures, options, swaps, and foreign exchange contracts.
- Nontraditional Equity
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Nontraditional EquityDerivative Income
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Derivative income strategies primarily use an options overlay to generate income while maintaining significant exposure to equity market risk. Income is typically generated through covered call writing strategies, for example, while traditional equity risk factors dictate a substantial portion of the return.
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Nontraditional EquityLong-Short Equity
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Long-short equity portfolios hold sizeable stakes in both long and short positions in equities, exchange-traded funds, and related derivatives.
- Allocation
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AllocationGlobal Allocation
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Global-allocation portfolios seek to provide both capital appreciation and income by investing in three major areas: stocks, bonds, and cash. While these portfolios do explore the whole world, most of them focus on the U.S., Canada, Japan, and the larger markets in Europe.
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AllocationTactical Allocation
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Tactical allocation portfolios seek to provide capital appreciation and income by actively shifting allocations across investments. These portfolios have material shifts across equity regions, and bond sectors on a frequent basis.
- Taxable Bond
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Taxable BondNontraditional Bond
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Inclusion in nontraditional bond is informed by a balance of factors determined by Morningstar analysts. Funds in this group typically have the flexibility to manage duration exposure over a wide range of years and to take it to zero or a negative value.
- Miscellaneous
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MiscellaneousTrading - Miscellaneous
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These funds seek to generate returns equal to a fixed multiple (positive or negative) of short-term returns of an index that is not equity, fixed-income, or commodity linked. Many of these funds seek to generate a multiple of the daily or weekly return of the reference index. Trading funds are not considered suitable for a long-term investor and are designed to be used by active traders.
How will I know if liquid alternatives are a good choice for me?
While this isn't an easy question to answer, investors who are comfortable with short-term volatility and have a high tolerance for risk may find liquid alternative ETFs to be a good choice—if they are able to devote the considerable time and energy necessary to fully understand these products. Conservative investors who aren't comfortable with complex or high-risk products should probably steer clear.
Also, investors should think carefully about their time horizon before investing in liquid alts. Because these products are prone to both short-term volatility and longer-term underperformance, investors will want to carefully consider how these products may fit with their investing goals. And yet, it's also important for investors to be flexible! Liquid alternative ETFs are more likely than other types of ETFs to close, which could result in an unexpected tax situation and follow-up research to choose a replacement fund.
Finally, if you think liquid alternative ETFs might be right for you and you spend some time digging into liquid alts, but find yourself with more questions than answers … you're not alone! These complicated strategies are difficult to understand and should be expected to generate unpredictable and potentially volatile returns. To avoid having liquid alternative ETFs leave a sour taste in your mouth, do as much research as possible. Ask lots of questions, ask some follow-up questions, and then ask even more questions! At the end of the day, these products are only suitable for investors who are fully educated and braced for unexpected outcomes (sort of like a sugar-free lime cola).
1 Alitovski, E., et al., "2021 Global Liquid Alternatives Landscape," Morningstar, July 2021, page 2.
2 Liquid alternative exchange-traded notes (ETNs) are technically uncollateralized debt.
3 Alitovski, E., et al., "2021 Global Liquid Alternatives Landscape," Morningstar, July 2021, page 7.
4 Armour, B., et al., "2021 U.S. Fund Fee Study," July 2022, page 3.
5 Alitovski, E., et al., "2021 Global Liquid Alternatives Landscape," Morningstar, July 2021, page 12.
Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Investing involves risk, including risk of loss.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. An investment in any offering made available through any third-party platform is speculative and involves a high degree of risk. Investors may lose all or a substantial portion of their investment. Alternative investment often employ leverage and other speculative practices that increase an investor's risk of loss, often charge high fees, may require investors to satisfy capital calls, and can be highly illiquid and volatile. These investments may lack diversification, involve complex tax structures and have delays in reporting tax information.
Digital currencies, such as bitcoin, are highly volatile and not backed by any central bank or government. Digital currencies lack many of the regulations and consumer protections that legal-tender currencies and regulated securities have. Due to the high level of risk, investors should view Bitcoin as a purely speculative instrument.
Currencies are speculative, very volatile, and not suitable for all investors.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options." Supporting documentation for any claims or statistical information is available upon request.
Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss. With long options, investors may lose 100% of funds invested. Spread trading must be done in a margin account. Multiple leg options strategies will involve multiple transaction costs.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
International investments are subject to additional risks such as currency fluctuation, geopolitical risk and the potential for illiquid markets.
Fund categories:
Digital Assets: Digital assets that utilize blockchain technology can be described as an immutable, permissionless and often decentralized digital database. Digital asset portfolios will invest the majority of their assets into one or more broadly classified areas including: Decentralized Finance (DeFi) assets, stable coins, currency assets, smart contracts platforms, exchange assets, privacy assets, yield farming, and nonfungible tokens (NFTs) among others. Digital assets are often characterized by two risk style factors: momentum and volatility. Portfolios may gain access to digital assets through physical or derivative exposures and incorporate both long-only investments and other hedging techniques. To qualify for inclusion, funds in this category must have a material portion of risk coming from digital assets.
Equity Market Neutral: Equity-market-neutral strategies attempt to profit from long and short stock selection decisions while minimizing systematic risk created by exposure to factors such as overall equity market beta, sectors, market-cap ranges, investment styles, or countries. They try to achieve this by matching long positions within each area against offsetting short positions, though they may vary their exposure to market risk factors modestly. These funds' investment strategies may be discretionary or systematic, and they keep at least 75% of their gross assets in equities or equity-related instruments such as derivatives. They typically have beta values to a relevant benchmark of less than 0.3. Beta is a measure of a stock's volatility in relation to the overall market. By definition, the market, such as the S&P 500 Index, has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0.
Event Driven: Event-driven strategies attempt to profit when security prices change in response to certain corporate actions, such as bankruptcies, mergers and acquisitions, emergence from bankruptcy, shifts in corporate strategy, and other atypical events. Activist shareholder and distressed investment strategies also fall into this category. These portfolios typically focus on equity securities but can invest across the capital structure. They typically have low to moderate equity market sensitivity since company-specific developments tend to drive security prices.
Macro Trading: Macro-trading strategies, using either systematic or discretionary methods, look for investment opportunities by studying such factors as the global economy, government policies, interest rates, inflation, and market trends. As opportunists, these funds are not restricted by asset class and may invest across such disparate assets as global equities, bonds, currencies, and commodities, and make extensive use of derivatives. Although these strategies aim to provide returns that are not correlated to traditional market indexes over a full market cycle, they can take significant directional long or short positions on any asset class over short periods and may have relatively high portfolio turnover.
Multi-strategy: Multi-strategy portfolios offer investors exposure to two or more alternative investment strategies, as defined by Morningstar's alternative category classifications, through either a single-manager or multi-manager approach. Funds in this category typically have a majority of their assets exposed to alternative strategies, but at a minimum, alternatives must comprise greater than 30% of the strategy's gross exposure. The category includes funds with static allocations to alternative strategies as well as those that tactically adjust their exposure to different alternative strategies and asset classes. Multi-strategy funds typically aim to have low to modest sensitivity to traditional market indexes, although that may not be the case for strategies with lower alternatives allocations.
Options Trading: Options trading strategies use a variety of options trades, including put writing, options spreads, options-based hedged equity, and collar strategies, among others. In addition, strategies in this group that engage in option writing may seek to generate a portion of their returns, either indirectly or directly, from the volatility risk premium associated with options trading strategies. Funds in the category will typically have beta values to relevant benchmarks of less than 0.6.
Systematic Trend: Systematic trend strategies primarily implement trend-following, price-momentum strategies by trading long and short liquid global futures, options, swaps, and foreign exchange contracts. The remaining exposure may be invested in a mix of other complementary nontraditional risk premia. These portfolios typically obtain exposure referencing a mix of diversified global markets, including commodities, currencies, government bonds, interest rates and equity indexes.
Derivative Income: Derivative income strategies primarily use an options overlay to generate income while maintaining significant exposure to equity market risk. Income is typically generated through covered call writing strategies, for example, while traditional equity risk factors dictate a substantial portion of the return. Funds in the category will typically have beta values to relevant benchmarks of between 0.6 and 0.9.
Long-Short Equity: Long-short equity portfolios hold sizeable stakes in both long and short positions in equities, exchange traded funds, and related derivatives. Some funds that fall into this category will shift their exposure to long and short positions depending on their macro outlook or the opportunities they uncover through bottom-up research. At least 75% of the assets are in equity securities or derivatives, and funds in the category will typically have beta values to relevant benchmarks of between 0.3 and 0.8.
Global Allocation: Global-allocation portfolios seek to provide both capital appreciation and income by investing in three major areas: stocks, bonds, and cash. While these portfolios do explore the whole world, most of them focus on the U.S., Canada, Japan, and the larger markets in Europe. It is rare for such portfolios to invest more than 10% of their assets in emerging markets. These portfolios typically have at least 10% of assets in bonds, less than 70% of assets in stocks, and at least 40% of assets in non-U.S. stocks or bonds.
Tactical Allocation: Tactical Allocation portfolios seek to provide capital appreciation and income by actively shifting allocations across investments. These portfolios have material shifts across equity regions, and bond sectors on a frequent basis. To qualify for the tactical allocation category, the fund must have minimum exposures of 10% in bonds and 20% in equity. Next, the fund must historically demonstrate material shifts in sector or regional allocations either through a gradual shift during three years or through a series of material shifts on a quarterly basis. Within a three-year period, typically the average quarterly changes between equity regions and bond sectors exceeds 15% or the difference between the maximum and minimum exposure to a single equity region or bond sector exceeds 50%.
Nontraditional Bond: Inclusion in nontraditional bond is informed by a balance of factors determined by Morningstar analysts. Those typically include a mix of: absolute return mandates; goals of producing returns not correlated with the overall bond market; performance benchmarks based on ultrashort-term interest rates such as T-bills; the ability to take long and short market and security-level positions using a broad range of derivatives; and few or very limited portfolio constraints on exposure to credit, sectors, currency, or interest-rate sensitivity. Funds in this group typically have the flexibility to manage duration exposure over a wide range of years and to take it to zero or a negative value.
Trading – Miscellaneous: These funds seek to generate returns equal to a fixed multiple (positive or negative) of short-term returns of an index. The reference index for this category is not equity, fixed-income, or commodity linked. The compounding of short-term returns results in performance that does not correspond to those of investing in the index with external leverage. For example, a fund attempting to achieve 2 times the returns of a given index on a daily basis is unlikely to deliver anything like 2 times the index's returns over periods longer than one day. Many of these funds seek to generate a multiple of the daily or weekly return of the reference index. Trading funds are not considered suitable for a long-term investor and are designed to be used by active traders.
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