Embracing liquid alternatives for investors at all levels

Financial advisers, take notice — liquid alternatives are fast becoming “the new black.” Over the past few years, the term “liquid alternative” has become part of the vernacular in references to nontraditional investment strategies that don’t fully qualify as pure alternative investments.

Although some alternative investing purists might shun this category of registered and more regulated products as being too retail-oriented, there are reasons to believe that liquid alternatives make sense for investors at all levels.

The liquid-alternatives segment, which generally refers to mutual funds and exchange-traded products that employ various hedging and leverage techniques, rarely stacks up evenly against true alternatives such as hedge funds and private-equity funds.

Likewise, liquid-alternative products really can’t be measured against traditional long-only mutual funds and ETFs.

HYBRID ASSET CLASS

Advisers and investors need to start embracing the idea of liquid alternatives as a hybrid asset class, which also means rethinking portfolio allocations.

Much has been made of the so-called liquidity premium that investors absorb when using liquid alternatives instead of directly investing in a hedge fund or private-equity fund.

“It’s kind of along the lines of “the emperor has no clothes,’ because it’s not something everyone wants to hear,” said Mark Goldberg, a managing director at W.P. Carey & Co. LLC.

For example, a direct investment in a private-equity fund requires a multiyear lockup period but also introduces a risk premium of about 18% over risk-free assets.

However, according to Mr. Goldberg’s analysis, when a private-equity strategy is offered in the form of a mutual fund or ETF, the added liquidity benefit trims about 3 percentage points from the risk premium.

“There are a lot of benefits to buying liquid alternatives, but you do give up something,” he said. “These products are designed to create some liquidity in the alternatives space, but people need to understand that liquidity comes at a cost, and anyone telling you that it’s not so is denying all the research that has been done in this area.”

Similar thinking should be applied when comparing liquid alternatives with traditional mutual funds and ETFs. The tendency is to dwell on performance comparisons and overlook the diversification benefits, which is the real reason to use alternatives.

A new report from the Money Management Institute, “MMI Industry Guide to Managed Investment Solutions — Trends and Statistics,” studied the benefits of liquid alternatives in investor portfolios that also include alternatives such as hedge funds.

As the report details, much of the modern use of alternative investments by individual investors is based on models used by endowments and foundations that could have up to 80% invested in alternatives.

But individual investors — even wealthy ones — don’t have the same profile as institutions, which is why liquid alternatives can play a role.

“The institutional model is important, and we can benefit from it, but we don’t want to replicate it for everyone, and that’s why it needs to be customized for individuals,” said Jean Sullivan, managing principal at Dover Financial Research LLC and author of the MMI report.

GROWING TREND

In predictable fashion, the financial services industry is all over the liquid-alternatives trend.

Morningstar Inc. is tracking 305 alternative strategy mutual funds with more than $85 billion under management.

That compares with 272 funds with $73 billion at the start of the year and 224 funds with $59 billion at the start of 2011.

ETFs in this sector, on the other hand, are still finding their footing. Reflecting the overall ETF market, which experienced a record number of closings in the first nine months this year, liquid-alternative ETFs haven’t grown as quickly as their mutual fund counterparts.

Morningstar counts 335 ETFs with $38 billion, compared with 335 ETFs with $42 billion at the start of the year and 251 ETFs with $39 billion at the start of 2011.

Financial Research Corp., which calculates a broader definition of the category, measures total liquid-alternative assets at more than $300 billion and predicts that those assets will grow to $650 billion in the next five years.

Although traditional allocations to alternative investments historically have been seen as static pieces of a portfolio, the expanding market of liquid alternatives is creating new tactical opportunities within portfolios, according to Ms. Sullivan.

She explained that it is now possible, and even practical, to use liquid alternatives to manage beta and alpha exposure more actively in the portion of a portfolio dedicated to alternatives.

[email protected] Twitter: @jeff_benjamin