Alternatives

As hot as liquid alts are, most can’t compete against the bull market

'The only thing that's working right now is the S&P'

Another strong year for stocks and another round of head scratching for investors in liquid alternative strategies that are mostly designed to hedge the risks associated with market downturns.
While there are always exceptions when it comes to alternative strategies — because performance dispersion can be extreme — the general sense is that most liquid alts are not yet living up to their promise and potential.
“There are a handful of good strategies that charge decent fees, but there are also a lot of funds that haven’t been proven yet and that charge too much,” said Jason Kephart, an alternatives mutual fund analyst at Morningstar Inc.
Some might see that as harsh criticism for the fast-growing and diversified universe of 538 registered alternative-strategy mutual funds, which includes more than $315 billion under management.
The total liquid alternative fund count is up from 427 and $264 billion at the end of 2013.
Mr. Kephart cites long-short equity funds, which averaged a 3% gain for the year through Nov. 30, as an example of where investors might not be getting what their money’s worth.
The S&P 500 Index over the same 11 months was up 14%.
While it isn’t entirely fair to compare a strategy designed to hedge risk against a pure long-only index, the liquid alts universe was tested during a stretch of market volatility in the early fall, and mostly failed.
Between Sept. 18 and Oct. 15, the S&P fell by 6%, and the long-short equity fund category average decline was 4.3%, which means the funds were capturing two-thirds of the downside.
“It looks like the stock-picking wasn’t working,” said Mr. Kephart.
Brad Alford, chief investment officer at Alpha Capital Management, which runs two multi-strategy mutual funds, agreed that liquid alts have not been keeping pace with the stock market, but also pointed out that they’re not designed to.
Underscoring the fact that alternative strategies are generally designed to smooth overall portfolio volatility, Mr. Alford said hedging doesn’t look good when the stock market is moving virtually straight up.
“Unfortunately, diversification is not working right now, because the only thing that’s working right now is the S&P,” he said. “Until the S&P slows down, any type of diversification strategy is not going to look sexy or appealing, but if alternatives tried to keep up with the S&P we would be taking on too much risk.”
With that in mind, Mr. Alford said investors should be paying attention to the relative risk, not performance compared against the S&P.
Mr. Alford’s Alpha Defensive Alternatives Fund (ACDEX), for example, gained 3% this year through November, but the fund’s three-year volatility measured by standard deviation is 2.99. By comparison, the SPDR S&P 500 ETF (SPY) has a three-year standard deviation of 9.
In fact, the standard deviation of most truly hedged liquid alt strategies will be closer to that of the bond market, as represented by the iShares Core US Aggregate Bond ETF (AGG), which has a standard deviation of 2.75.
Performance-wise, Mr. Alford’s fund did beat the multi-strategy fund average through November of 2.75%.
But, as Mr. Kephart pointed out, the multi-strategy category is one of the more challenging strategies to run in a mutual fund format because it generally has higher fees and it often requires the willingness of hedge fund managers to manage the underlying assets at lower fee levels than hedge fund managers typically earn.
The best-performing liquid alts strategy through November was managed futures, which produced a 7% average gain. But, like all liquid alt categories, the performance dispersion among the funds in the group is far and wide.
Within the managed futures category, performance through November ranged from a 21% gain by Natixis ASG Managed Futures Strategy (ASFYX) to a 4.4% decline by Hatteras Managed Futures (HMFAX).
That’s one big reason why investing in the alternatives space can be tricky.