Not so long ago, alternative investments—investments such as hedge funds, managed futures and private equity—were the exclusive domain of institutional investors and the ultra-wealthy. This was due to their net worth requirements, high minimum investments, long lock-up periods and other restrictions.
The advent of alternative mutual funds or “liquid alternatives” changed all this, opening up some of these strategies to retail investors. Because liquid alternatives are mutual funds, they are much easier to invest in and redeem (hence “liquid”), and tend to have lower minimum investments and fees than traditional alternative investments. This gives retail investors more opportunities for diversification beyond stocks, bonds and cash.
Investors—eager for additional diversification at a time when the returns of traditional assets have been moving in tighter alignment—have been pouring money into these funds. The value of assets managed by liquid alternatives jumped from $25 billion in 2005 to nearly $200 billion in 2014.1
Yet many investors are unfamiliar with exactly what liquid alternatives are. Let’s take a closer look.
Not your average mutual fund
One of the most notable things about liquid alternatives is that they can pursue a wide range of investment goals. For example, some funds seek to minimize downside risk while others attempt to outperform the broader stock market. It’s important to know what you are signing up for so read the fund’s prospectus carefully.
Another thing that liquid alternatives have in common is their use of non-traditional investments and trading strategies. In contrast to traditional mutual funds, which typically invest in just stocks, bonds and cash, liquid alternatives also consider assets such as futures, options, commodities and non-listed securities. They can also try to boost gains using non-traditional strategies such as leveraging or borrowing money to invest, shorting or hedging with derivative contracts.
Some liquid alternatives focus on a single strategy—for instance, they may invest exclusively in distressed securities. Other funds might use a long-short strategy where they buy (or are long) certain stocks, while selling (shorting) other stocks. Other alternative mutual funds may combine a variety of these and other strategies. Some operate as a “fund-of-funds” that invests in other alternative funds.
Broadly speaking, liquid alternative strategies fall into two camps: directional and non-correlating.
Part of a diversified portfolio
One of the most appealing aspects of liquid alternatives has been their diversification benefits. Because liquid alternatives invest in a large variety of assets and can use hedging strategies, they tend to perform very differently from investments in more traditional asset classes. That means liquid alternatives can serve as a risk management tool, potentially lessening the overall risk of a portfolio.
However, this category also encompasses a lot of different strategies and shouldn’t be grouped as a single solution. Liquid alternatives should be evaluated like any other investment. Certain strategies tend to perform better in rising market conditions, while others do a better job protecting in falling markets. There’s also the question of how skillful the manager of a particular fund is at executing his or her strategy, as well as the management fees they charge. Finally, every investor’s goals, risk tolerance and time horizon are different. How an investor incorporates liquid alternatives in his or her portfolio will depend on their personal circumstances.
Knowing that, we can still give a hypothetical example of what a portfolio that includes alternative investments might look like and then compare it with a more traditional version. The first pie chart below shows a traditional portfolio that is 60% stocks and 40% bonds. The second one shows a portfolio that includes alternative investments.
Next, we took a look at how these hypothetical portfolios would have performed from 2000 through the end of September 2015. As you can see, adding a small allocation to alternative investments would have delivered slightly higher returns (an annualized 5.21% vs. 4.84%) with less volatility (a standard deviation of 7% vs. 9%) over that period.
What are the risks?
Liquid alternatives have risks that should be taken into consideration. For one, they can use borrowed money to amplify the impact of market movements. Sometimes this can help—and sometimes it can hurt returns. Futures and other forms of derivatives also can be more risky than portfolios composed of stocks and bonds because they can magnify the impact of market movements. Again, that could mean bigger gains when markets are rising and bigger losses when they fall.
Democratizing alternative investments
Liquid alternatives provide individual investors with access to strategies similar to those that were once the exclusive domain of ultra-high net-worth investors. The potential diversification benefits can be an attractive addition to many portfolios. But the differences between these funds can be big, so make sure you do your research before investing.