An alternative way to go when searching for income

On his old “Coffee Talk” routines on “Saturday Night Live,” Mike Meyers played Linda Richman, a New Yorker who worshipped Barbra Streisand and had a knack for identifying commonly used phrases that were internally inconsistent and, when considered, made little sense. “The Middle East is neither in the middle nor in the east. Discuss.” How about, “The Partridge Family was neither a partridge nor a family. Discuss.”

The financial services industry has a number of two-word combos that could use some scrutiny from Ms. Richman. “Risk arbitrage” — arbitrage, in its purest form, is defined as risk free. Discuss. “Private equity” — yes, the companies are private and not publicly traded on a stock exchange but the asset class also consists of debt, not just equity. Discuss. And “hedge fund” — does this mean that the client’s returns are hedged against market risk? Discuss.

Institutional investors investing in hedge funds are presumed to be sophisticated and able to decide for themselves how much actual hedging is being done by their managers. Individual investors and their financial advisers, on the other hand, have traditionally not had to concern themselves with the inner workings of hedge funds that they were not allowed to buy. The explosion of new liquid alternative funds has changed the landscape and individual investors now have the opportunity to use the familiar mutual fund format to gain access to investment vehicles that include strategies previously reserved for institutions.

A good place to start thinking about the sector is to look closely at the term “liquid alternative.”
First, “liquid.” While all funds in the liquid alt space are, by definition, daily priced mutual funds that trade at their net asset value, that does not mean the underlying assets can in every case sustain a bad patch of investor redemptions. Discuss.
Second, “alternatives.” Putting non-traditional assets into a mutual fund may seem alternative by type of holdings, but is the result truly alternative to the other assets a client already owns? Discuss. For example, a leveraged investment in large capitalization U.S. equities held in a liquid alt fund will certainly have produced impressive returns through the first quarter of 2014, but shouldn’t investors be concerned about that investment’s correlation with core equity holdings?
(More: Five things you need to know before investing in liquid alts)

SEC rules for liquid alts give managers flexibility for asset class and security selection that is not found in traditional mutual funds. A review of the offerings finds many liquid alt funds with an absolute-return focus. Searching for liquid alt funds with an emphasis on income and capital preservation produces very few choices. At a time when large numbers of investors are worried about possible higher long-term interest rates and are holding abnormally large amounts of their portfolios in cash equivalents earning essentially no returns, might a liquid alt structure be used to offer clients a worthwhile level of income without exposing them to undue risk?

In my opinion, an income-oriented liquid alt fund should have:

• Liquid underlying assets owned as part of a strategy that can scale up or down without regard to market conditions.
• Alternative (i.e., very low) correlations to both the equity and debt markets.
• Consistency of criteria for security selection.
• An expense ratio that does not gobble up the income being generated.

To achieve the above objectives, a liquid alt fund would need to step away from the familiar traps and tendencies of being a closet indexer or a momentum follower or a yield chaser.

U.S. equities are in the fifth year of a roaring bull market and interest rates may be moving up. A cautious investor sitting on the sidelines gives up the chance for capital appreciation and is “rewarded” with short-term, microscopic money market returns. Perhaps a little alternative income can play a role in a diversified portfolio? Discuss.

David Sand is chief investment strategist at Community Capital Management Inc.