Jeff Benjamin

Investment Insights: The Blogblog

Jeff Benjamin breaks down the game for advisers and clients.

As liquid-alt mutual funds proliferate, some question their value

Mar 25, 2014 @ 10:40 am

By Jeff Benjamin

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When the news broke this month that $24 billion hedge fund firm Grosvenor Capital Management was breaking out of its otherwise secretive shell with plans to launch a registered alternative strategy mutual fund, it was generally interpreted as just the latest evidence of a continuing trend.

Grosvenor is simply following the likes of Arden Asset Management, The Blackstone Group, and K2 Advisors by migrating downstream toward an expanding and increasingly curious investor base, which includes financial advisers.

Five years ago, such a move by a hedge fund shop like Grosvenor might have triggered several enthusiastic hours or even days of financial news analysis.

Fifteen years ago, a move by such an off-limits hedge fund shop was virtually unheard of because it would represent a violation of that invisible but well-understood wall separating hedge fund investors from the great unwashed, otherwise known as mutual fund investors.

But, even though it would be easy to argue for portfolio diversification through the use of alternative strategies, there is scant evidence that the flood of liquid alternative products now pouring into the mutual fund market is doing much more than confusing investors and frustrating financial advisers.

“It's a generalization, because there are some decent portfolio managers out there, but I don't believe the mutual fund space is jam-packed with rock star hedge fund managers,” said John Shearman, chief executive of financial advisory firm IV Lions.

Mr. Shearman is not anti-alternatives. In fact, he allocates between 20% and 30% of his clients' assets to alternative strategies.

But, as a former hedge fund consultant, he is savvy enough to recognize what is being created in the alternative-strategy mutual funds space.

“We know that accessing the best managers is difficult even if you're representing a multi-billion-dollar Harvard endowment,” Mr. Shearman added. “You have to ask why anyone would manage a mutual fund if they could be managing a hedge fund.”

Part of the answer to that question boils down to simple economics. As alternative strategies become more liquid, hedge funds are having a harder time charging the industry standard 2% on assets and then taking a 20% performance fee.

The mutual fund industry, meanwhile, has been carving out its own piece of the action.

By the latest count, according to Morningstar Inc., there are now 429 distinct alternative-strategy mutual funds, representing nearly $145 billion.

That includes 70 new funds and more than $40 billion added just last year.

As recently as 10 years ago, there were only 116 alternative-strategy mutual funds, representing less than $22 billion.

“The good news for investors who believe in using alternative investing tools is that they are now more readily available, because the strategies are no longer reserved for the Yale endowments and pension funds of the world,” said John Nersesian, chairman of the Investment Management Consultants Association.

“The bad news is, more does not always equal better,” he added. “With so many more products now available, the investor and the adviser need to be that much more discerning.”

Earlier this month IMCA partnered with the Chartered Alternative Investment Analyst Association to launch the fundamentals-of-alternative-investments certificate program to help better equip advisers to use alternative strategies.

As the hedge fund industry and traditional mutual fund industry continue to crank out products designed to attract the growing appetite for alternatives, financial advisers will need all the help they can get.

“Right now across the liquid alts space the offerings have been so inferior,” said Dan Thibeault, president and chief executive of GL Capital Partners, a firm that manages both a hedge fund and two alternative-strategy mutual funds.

The regulations governing mutual fund trading and operations will restrict most alternative strategies from perfectly replicating a pure limited-partnership or hedge fund strategy, but that's not even the biggest concern, according to Mr. Thibeault.

He cites the common gripe of higher fees, which average 1.87% across the liquid-alternative market, or about 65 basis points above that of the average actively-managed mutual fund.

On top of that, most liquid-alt funds charge some type of sales load.

The fees obviously contribute to a performance lag that can't always be explained away by correlation principles.

In theory, a strategy designed to hedge the risk of the broader equity market would underperform the S&P 500 Index during a bullish run like last year's, when the index gained more than 30%.

But since the market has been charging almost straight up for most of the past five years, the majority of alternative strategies that were launched in the past few years have yet to be fully tested.

“We start with the notion that if you're going into an alternative you have to have a high degree of potential to get non-correlated returns,” Mr. Thibeault said. “But we looked at the universe and found that only nine funds out of more than 400 have negative beta over the past five years.”

Further, Mr. Thibeault found that the average beta of the liquid-alt-fund universe is 1.06, and that 75% of the funds have a beta of more than 0.7, both of which imply a lot more market correlation than most alternative investors probably want.

“The first condition you should satisfy is lack of market correlation, and once you get that you hope you could at least get risk-adjusted returns or alpha above market returns,” he said. “If you just start with that notion, I'd say the liquid-alt sector in general fails miserably.”


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