Long/short equity, event-driven liquid alt funds top stocks in first half

Flows turn mixed but overall universe expected to grow by 5% this year to about $495 billion.

Are you more afraid of a snarling dog or a warm fluffy bed? It sounds like a silly question, but given an unpredictable animal versus fluffy mound with no teeth, I’d hazard the former. Wrong. As many as 728 people accidentally suffocate in bed on average each year in the U.S. versus 32 deaths caused by dogs, according to data from the Centers for Disease Control and Prevention assembled by BuzzFeed. How about when you throw a shark into the mix? Nope, the prior two are still far more dangerous given that a shark attack resulting in death only occurs once a year on average.
In BuzzFeed typical fashion, they list “24 Things That Kill More People Than Sharks In America”. Here are some worth mentioning:
• Pajama fires (kill 4 people)
• Spiders (6)
• Starvation or dehydration from self-neglect (26)
• Canoes and kayaks (35)
• Falling from trees (85)

Basically, you’re more likely to starve yourself than get eaten by a shark. In other words, our fear is statistically misplaced. Our hearts beat faster when hang gliding (kills 5 people annually) than when participating in an everyday hygienic practice (drowning in bath tubs kills 391 people annually). We think we know and understand risk, but we really don’t.
Life, just like the capital markets, is full of risks — the key is learning how to manage fear. The best solution relative to investing is through diversification. As simple as this concept is, we often forget it in the midst of bull markets. Investors flock to risk assets due to a fear of missing out on higher returns, and assets with lower risk and correlation to stocks fall out of favor. Fair enough. But our economy and financial system churns in cycles and the current rally is growing elderly relative to prior rallies and is about to lose its cane of easy monetary policy from the Federal Reserve.
(More: Private equity shop Apollo jumps into liquid alts )
Fortunately for investors, they now have access to more options of non-correlated assets than they did prior to our last financial crisis. For example, liquid alternatives — hedge fund strategies in mutual fund or exchange-traded fund wrappers — were first introduced about a decade ago, but the number of funds proliferated after the 2008 crash. Investors developed a larger appreciation for products that could improve their diversification profiles. Liquid alts help accomplish this goal since they tend to sport lower correlations to other asset classes, thereby pushing portfolios further out on the efficient frontier.
We’ve written about this burgeoning asset class each month since my co-author and I published a book on the topic — called Alts Democratized — last December. For this month’s installment, we review the strategies with notable performance and net flows data during the first half of this year out of Lipper’s eleven classifications. All data below was provided by Lipper.
Let’s start with what’s worked in the first half of 2015. Overall, most classifications earned solid returns in the first quarter, but struggled in the second quarter. A few data points to kick off the discussion:
• For example, alternative long/short equity funds, which enter into both long and short positions in equities, equity options and equity indexes, returned 1.6% in the first quarter. This classification ended the first half up 1.2%, as the category lost 0.45% in the second quarter. Nevertheless, these funds still beat the S&P 500 (+0.20%) during the same time period.

• A similar strategy, alternative active extension funds, which seek a 100% net long exposure (the most common allocation is 130/30), lagged in terms of returns from January through June compared with the prior category, up 0.86% (+0.98% in the first quarter, -0.14% in the second). These funds, however, gained 7.5% year over year versus 1.4% for long/short equity.

• Both classifications unsurprisingly attracted flows this year in light of the 6+ years of advances in the stock market, as they both have equity tilts: Long/short equity ($39.3 billion total net assets) drew in $1.5 billion and active extensions funds ($14.6 billion) gained $268 million.
Event driven funds also delivered decent returns this year, up 1.1% in the first half. However, a net $821 million worth of money left these funds in 2015 ($10.4 billion total net assets). Investors may still anchor their investments off of the performance of last year — one-year return of negative 0.65% — a common behavior of investors in liquid alt strategies. We expect event driven funds to gain flows in the balance of this year as the current investment environment is ripe with opportunities for this strategy, which captures corporate events: record levels of mergers and acquisitions, large cash levels among companies, low interest rates and heightened activism. For a longer time perspective, this classification earned an average five-year return of 4.4%.
(More: Goldman pares down liquid alts, presses Morningstar to follow suit)
Moving on now to what’s not worked this year through June. The biggest loser was dedicated short bias funds, down 7.00%. These funds are highly leveraged as they seek to capture the inverse or negative multiple of an index’s return. Despite weak performance as a classification, it brought in a net $951.5 million ($13.7 billion total net assets) during the first half. These strategies are typically employed by professional traders and have high turnover &mdash they are used to hedge or make tactical bets.
Alternative managed futures funds also ended the first half in a disappointing fashion given their big comeback in the first quarter. These funds grew in popularity after the managed futures strategy delivered positive double digit returns when the stock market posted double digit losses in 2008. The low volatility/high correlation environment that followed acted as a headwind to this strategy, causing it to underperform over the last few years. Managed futures funds latched on to strong trends that began in 2014 and extended into the first quarter, resulting in a return of 5.9% for the period. These funds encountered price corrections, however, in four major market sectors during the second quarter; the U.S. dollar, interest rates, and equity indexes (particularly in Europe) sold off, while commodities (i.e., crude) rallied. Consequently, the strategy fell 0.84% in June from January after retreating an average of 6.3% in the second quarter. Even still, the classification is up 9.8% year over year as of the end of June.
Last, we’ll highlight a classification that’s a mixed bag in terms of performance and net flows, but offers an opportunity for the back half of this year. Alternative credit focus funds lagged the Barclays Aggregate Bond Fund in the first quarter (+0.88% vs. 1.22%). But as the AGG lost 2.21% in the second quarter, credit focus funds were only down 0.26%. They were also positive for the first half of 2015, up 0.62% compared with a negative 1.19% for the AGG. Credit focus funds’ edge over long-only fixed income products is that it can invest in a wide range of credit structured vehicles and is not constrained to an index. This classification lost $1.5 billion in net flows during the first half, but we expect it to attract more money going forward this year and into 2016. Many of these funds maintain low durations, which can help protect against rising interest rates — an attractive feature as the Fed’s rate hike nears.
Overall, net flows into liquid alts have slowed over the past few years, as to be expected as these products typically lag the market during bull markets due to their low correlation. They attracted $65 billion in 2010, just shy of $50 billion over the next two years, took in an impressive $115 billion in 2013, but only gained $30 billion last year. Flows were actually negative in the first half of this year by $6.5 billion. With that said, volatility picks up in the fall and usually peaks in October historically through the course of each year. Layer on the impending raise in short-term interest rates by the Fed, and investors will seek other forms of diversification.
Therefore, we believe the liquid alts universe will grow by 5% to about $495 billion by year’s end from $470.8 billion in 2014, about in line with last year’s 6% year over year growth. The real test for liquid alts will present itself during the next bear market in terms of performance and investor demand. At least in anticipation for the next significant correction, investors have greater access to more sophisticated strategies to better diversify their portfolios.