Hedging on Liquid Alternatives

Asset managers have a simple rationale for liquid alternatives.

“In general, institutional investors are seeking alternative assets that have reasonable long-term return expectations and are not highly correlated to traditional assets,” Tom Lee, Parametric’s investment strategist, explains. “If they can get them in a form that’s liquid and transparent, that’s great.

Offered largely in mutual fund form—but also accessible as separately managed accounts—liquid alternatives have been marketed as a way to bring alternatives to the masses. The sales pitch? All the diversification benefits of a hedge fund, without the 2-and-20 fee structure and a lengthy lock-up period—and available in a format easily accessible by the everyday investor.

But institutional investors are not your everyday investor. With long-term investment horizons, they can afford a little illiquidity; with a large scale, they don’t need to turn to mutual funds for diversification.

So could Lee be right? Can liquid alternative strategies appeal to those investors with access to the real deal?

“We wouldn’t make the blanket statement that yes, there’s an opportunity, but there are strategies and management teams in the liquid alternatives space that are attractive,” says Jonathan Miles, a managing director at Wilshire Consulting and head of its hedge fund advisory. Some of the characteristics that set liquid alts apart from the traditional illiquid versions—liquidity, fee transparency, regulatory oversight, regular reporting—could be very enticing to institutional CIOs and boards, he adds.

“Any institutional investor who has liquidity constraints—clearly this would be a good way for them to get diversification,” agrees Jordan Nault, Mercer’s head of hedge fund research. “Even plan sponsors that don’t have liquidity constraints may find some liquid alternatives pretty interesting depending on governance models.”

The mutual fund fee model in particular stands out as a potential driver of interest in liquid alternatives. Hedge fund benefits without the hedge fund prices? Count us in.

“It’s about understanding what the tradeoffs are,” Miles says. “Can I implement what I want to do, which is invest in diversifying strategies, without paying the incentive fees? That’s where liquid alternatives can come in.” These tradeoffs depend on the particular liquid alternative, he adds. All liquid alts are, by definition, liquid—and not all alternative strategies can be recreated in a liquid form.

“There are a number of hedge fund managers that have launched liquid versions of their flagship fund,” Nault says. “But the manager does have to compromise a bit with respect to the strategies they’re able to include. They might have to leave out some of their good ideas because it doesn’t work in a liquid structure.”

Those that can be replicated in a liquid strategy, according to Nico Amato, head of alternatives portfolio management at Wilshire Funds Management, are the ones that are fairly liquid to begin with: equity-based options such as global macro and equity hedge, along with some event-driven strategies like merger arbitrage. Credit-­oriented and relative value strategies, however, may not work as well in a liquid vehicle. “In the liquid alts world you can’t really take advantage of an illiquidity premium,” says Amato. “We can’t have a liquid alt investing in illiquid securities.”

The liquidity requirement isn’t the only strategy constraint. Liquid alts also can’t incorporate nearly as much leverage or concentration as a hedge fund might. “You might have an equity hedge manager with a 10% position in one spot that differentiates him from other equity hedge managers because he’s taking a very idiosyncratic bet,” Amato adds. “But within mutual funds and liquid alts, regulation doesn’t allow managers to have a 10% position in a security.”

That additional regulation could be an upside. For smaller funds without the resources of a robust internal staff or sophisticated board, liquid alternatives can provide a means to forego some of the extensive due diligence necessary to invest in alternatives.

“It takes a lot of work to invest in alternatives,” says Miles. “To understand a hedge fund strategy, the structures, the terms, the limited transparency—that level of work usually requires a certain level of scale in your assets.” Liquid alternatives, he explains, take away some of that operational risk. “Smaller, midsize plans that don’t have the resources or the staffing to do the operations assessment can avoid it.”

What about the funds that do have the resources? Should the New York State Common Retirement Fund or the Yale endowment bother with what could just be an oversimplified version of hedge funds already in their portfolios?

“If you’re a large institutional investor with a dedicated staff or sophisticated investment committee we would typically advise that you invest in private markets and hedge funds and those types of alternative asset classes,” Nault says. “I don’t see a strong reason to invest in liquid alternatives.”

Back at Parametric, where the quant manager has recently added a smart beta-like liquid alternative to its roster of volatility risk premium strategies, Tom Lee disagrees.

“Post-financial crisis, investors have realized that liquidity has a premium,” he argues. “If I’m going to hand you my money and you’re going to lock it up for three years, you need to pay me extra for that.” But disappointing hedge fund returns have led some investors to feel they haven’t been compensated enough for that liquidity premium, he adds. “If they think they can capture this alternative risk premium in a way that still provides them liquidity, all else being equal, they’ll take it.”

Of course, all else is not equal. The strategy constraints and the liquidity requirements mean that liquid alts may offer similar diversification benefits as traditional alternatives, but they cannot deliver the same performance: Wilshire’s liquid alternative index trails the HFRI hedge fund index in one-, three-, five-, and ten-year returns.

“We would never expect a pure liquid alts portfolio to beat pure hedge funds because it’s not investing in the same assets,” Miles says.

At the end of the day, the potential usefulness of a liquid alternative product to an institutional investor comes down to the specific needs of the portfolio in question. At the New Mexico Public Employees Retirement Association (PERA), for example, CIO Jon Grabel and his team are in the process of migrating to a new strategic asset allocation—and liquid alternatives have proven helpful in transitioning the portfolio.

“In our real assets portfolio, we have an allocation to liquid infrastructure,” Grabel explains. “Over time—and this may take five years—we will use that to fund our commitments to illiquid infrastructure investments. It’s a way of using a more liquid strategy to build beta for a particular segment of the portfolio.”

In another case, PERA created a liquid alternative structure that made sense for them by customizing a portable alpha program at AQR—a manager that is currently dominating the liquid alts space. But while Grabel says it’s nice to have that extra liquidity, he still believes in the benefits of traditional lock-up alternatives.

“We never sat down and made a decision to use liquid alternatives as opposed to illiquid alternatives,” Grabel says. “We still believe there is an illiquidity premium for certain strategies. It’s about choosing the strategies that are helpful for what we believe is the best way to implement our portfolio.”