Frozen Liquidity Problem Solved, Kinda, So Alts’ Popularity Grows

Art by Ryan Peltier

Here’s the problem with liquidity. Sometimes it freezes solid. Just ask hedge fund investors who tried to withdraw their money during the 2008 financial crisis. Too often, they couldn’t.

Liquid alts are created to be an answer to that dilemma. They’re increasingly popular because they promise the virtues of diversification—that is, they’re not correlated to those conventional investing stalwarts, stocks and bonds—and yet you can liquidate them. That is, get your money out when you need it.

Hedge funds just happen to fall into the alts category. So do a bunch of other asset groups, such as real estate and private equity. According to research firm Greenwich Associates, hedge funds, real estate, and PE are the most popular liquid alts categories. Read: the kind that typically are hard to cash out from.

While liquid alts will hardly inoculate investors from market routs, they performed better than the S&P 500 amid the financial crisis, depending on the strategy. The most popular hedge fund alt strategy is absolute return, which aims to beat a benchmark. Alas, it lost 42% in the crisis. Ditto for the next most popular: Long-short (where shorting should offset market slides) dropped 39%, and market neutral (a variation on long-short) 8%, wrote Nicolas Rabener, in a study published on the CFA Institute’s blog.  

On the plus side, those didn’t do as badly as the S&P 500’s 57% plunge during the crisis. Yet “an investor in an absolute return fund would hardly have been pleased with a 42% drawdown,” noted Rabener, managing director at FactorResearch in London.

That raises the question of how liquid alts would fare in the next financial panic. Back in the nightmare time of 2008-09, real estate suffered the most, of course, as housing’s collapse was the catalyst for the crisis. Stocks were slammed, as were most other asset classes, except for Treasury bonds, viewed as risk-free with the taxing power of the US government behind them.

Such concerns are muted nowadays, though, so more and more investors are adopting liquid alts. Overall, liquid alt funds’ assets under management reached $321 billion at the end of September. That’s down from the $365 billion peak in mid-2014, when the surging stock market beckoned to investors. AUM has been climbing back since 2017 amid increased global tensions. 

Among institutions, Greenwich statistics show, liquid alts today make up 4% of total assets, of $882 billion, with an average 6% among public pension funds and 2% among corporate pensions.

A favorite vehicle for alt investing is the exchange-traded fund, which is about as liquid as you can get. Institutions now own $47 billion worth of liquid alts ETFs. Based on a survey of 107 senior fund professionals at large U.S. institutions, Greenwich expects these ETFs to double over the next 12 months.

“Given institutions’ embrace of ETFs in other asset classes and their ample appetite for alternatives, it’s possible—even likely—that large numbers of these investors will experiment with liquid alt ETFs,” said Andrew McCollum, managing director at Greenwich Associates.

How Liquid, Exactly?

Liquid alts are a testament to Modern Portfolio Theory, which espouses the benefits of combining assets with low correlations to one other, with the goal of lowering portfolio fluctuations and improving risk-adjusted returns. Say inflation picks up, then real estate prices tend to do well. Or a vicious bear market strikes: Precious metals are the go-to refuge of choice.

Hedge funds are meant to limit the damage. With alts, observed Justin Boller, director of fixed income for Liquid Strategies and Overlay Shares, “You have many flavors, with very different return objectives.”

Some alts obviously are more liquid than others. Agricultural and energy commodities, for instance, have robust trading mechanisms, from spot markets to futures exchanges. Even positions in private equity and hedge funds can be traded. Dozens of secondary shops, such as Landmark Partners, have been providing a market for these asset classes for years.

To Charles Van Vleet, CIO of Textron, such positions are “not illiquid, they are expensive liquidity.” In other words, they can be sold at a discount to third parties. The hitch to selling investments in PE or hedge funds is that “gated provisions” limit how much fund investors can redeem, so the funds aren’t forced to unload difficult-to-sell holdings to cash them out.

Nevertheless, “I can go to Landmark and sell a gated position for 10 points less its most recent GP valuation,” Van Vleet said. From the fund’s viewpoint, the position’s ownership is merely changing hands, substituting an old investor for a new one, thus the fund is unaffected.

What about really illiquid stuff, namely real estate? You can’t simply sell off a batch of office buildings on the spot. No secondary market exists that can take properties off your hands today so you can meet that margin call on an equity position tomorrow. The answer: Real estate funds make sure to have enough cash available to handle redemptions, Greenwich’s McCollum said. “At the end of a business cycle, cash is inching up,” he added.

The Performance Question

The cold truth remains that when the next financial meltdown comes, alts’ performances will be all over the place. And they may lose money.  A study by Reliance Capital Markets AA examined different asset classes over five financial crises ranging from the Federal Reserve’s surprise 1994 rate increase through the 2008-09 mess. The study found that managed futures did the best, gaining 14.3%. That more than offset those legacy stalwarts, stocks and bonds. Bonds earned a mere 0.78%, while large-cap stocks lost 15.6%.

Other than managed futures, however, individual alts didn’t deliver impressive returns over the five crises. Hedge funds lost 5.6%, private equity was down 6.8%, commodities dipped 6.5%, and real estate dropped 9.9%.

Since the Great Recession ended, uncommonly low interest rates and a belated, if tepid, economic rise has made the stock market king. Alts, for the most part, have trailed. Since the idea of alts is to provide diversification, not superior performance, it’s no surprise that this broad asset class lags stocks and even bonds lately.

Through this year’s third quarter, the Wilshire Associates Liquid Alt Index rose 5%. That’s nothing special compared to the S&P 500’s 20.5% increase and the Bloomberg Barclays US Agg’s 8.5%. And over 10 years to September 30, the alt index moved up a mere 1.9% annually, versus 13.2% for the S&P and 3.4% for the bond index Agg.

Because different alt strategies have their ups and downs, the exact mix one chooses can bring wildly different returns. Take managed futures, which are actively managed investments in futures contracts, meaning a heavy dollop of commodities—a great diversifier. The turbulence of the past few years, particularly from the US-China trade war, has been challenging for them.

An example is AQR Managed Futures Strategy, which  invests in not just in commodities, but also in currencies, stock, and bond futures. In 2019, the fund is on its fourth negative-performing year, as commodities have struggled. For instance, oil (8.6% of the fund, per Morningstar) has been in the dumps for the past half-decade, owing to global over-supply.  In its year-end 2018 shareholder letter, fund managers blamed its down spells over the past year to the slowing of  international growth  and political developments.

Alts vehicles have suffered casualties recently, as some were shuttered. Well Fargo last year ended its Alternative Strategies Fund, which sought low-volatility investments across a range of alt classes. The fund charged a hefty 2.8% in expenses yearly, perhaps due to its small size ($10 million).

Hedge funds have had a problematic record these days, with 2018 particularly lousy. Yet for the first half of this year, they were up 7.6%, says Hedge Fund Research, thanks to buoyant stocks and bonds, upon which most hedge strategies rest. While gains were more modest in September and October, at least they were positive.

Amid a roaring mergers and acquisition scene, private equity has logged a fine record, post-crisis. This asset class led all others with a 14.3% annualized showing for 10 years through 2018, the American Investment Council found. That bests the S&P 500’s 10.7%, scored amid the economic recovery.

But no guarantee exists that PE always will romp. In fact, the California Public Employees’ Retirement Systems reported its PE portfolio returned 7.7% in the fiscal year through June 2019, down from 16.1% in the prior year. Winning in private equity requires a bunch of high dollar exits, when acquired companies are sold to others. Without that, the results can be less robust. “When you have so much liquidity available, naturally the price for illiquidity will come down,” CalPERS Chief Investment Officer Ben Meng told Bloomberg News.

For alts, Liquid Strategies’ Boller said, “It pays to know what’s under the hood.” For many investors, in particular institutional ones, alts remain a good idea to drive them through a storm.

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