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LIQUID ALTERNATIVES: ALTERNATIVE ENOUGH?

Fake Alternatives?
September 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

This research note was originally published by the CFA Institute’s Enterprising Investor blog. Here is the link.

SUMMARY

Liquid alternatives offer hedge fund strategies in mutual fund format

The correlations to the S&P 500 have been high, even of market neutral funds
Diversification benefits have therefore been limited

DISRUPTING THE HEDGE FUND INDUSTRY

Liquid alternatives have been heralded as hedge funds for Main Street as these investment vehicles offer typical hedge fund strategies in mutual fund format with
daily liquidity. While they  have higher management fees than plain vanilla mutual funds, liquid alternatives charge less than hedge funds and don’t charge
performance fees.

Given their lower fees and greater transparency, liquid alternatives were expected to disrupt the hedge fund industry in much the same way that exchange-traded
funds (ETFs) disrupted the mutual fund space. However, ETFs have enjoyed continuous growth in assets under management (AUM), while liquid alternatives
have stalled at around $350 billion in AUM since 2013, according to data from Wilshire.

Hedge funds have experienced a similar stall, hovering at around $3 trillion in AUM over the last five years. Given strong equity markets, investors likely were
less inclined to hedge their portfolios. Moreover, hedge funds also failed to generate meaningful alpha.

So how do liquid alternatives perform from a risk-and-return perspective in the context of an equity portfolio, particularly the three largest groups in the liquid
alternative mutual fund space — absolute return, long-short, and market-neutral strategies?

LIQUID ALTERNATIVES PERFORMANCE

Long-short and long-only strategies are not comparable, so hedge funds and liquid alternatives shouldn’t be benchmarked to the S&P 500. But the S&P 500 can
illustrate the different phases of the market cycle.

The chart below highlights the similarity between the S&P 500 and an equal-weighted index of long-short liquid alternative mutual funds. This is to be expected
since long-short funds essentially offer equity exposure with lower volatility. In contrast, market-neutral funds are typically fully hedged and absolute return funds
allocate across asset classes, which results in much lower return profiles.

Source: FactorResearch

When it comes to risk-adjusted returns, long-short and market-neutral funds perform well. Absolute return funds generated less attractive risk-return ratios, which
is surprising since absolute return portfolio managers have the flexibility to create well-diversified portfolios. Perhaps this reflects the challenges of tactically
timing allocations to different asset classes like equities, bonds, or commodities.

Source: FactorResearch

UNCORRELATED RETURNS?

As their name implies, hedge funds short stocks in order to preserve capital. Similarly, liquid alternatives aim to provide returns that don’t correlate to traditional
asset classes. However, the analysis below shows that liquid absolute return and long-short funds are highly correlated to the S&P 500. That means they offer
little protection in a potential stock market crash. Market-neutral funds should have close to zero correlation to the S&P 500, but frequently have correlations
above 0.5.

Source: FactorResearch. Geeks might recognize the Quant Crash in August 2007.

This high correlation to the S&P 500 resulted in significant drawdowns in liquid alternatives during the global financial crisis in 2008 to 2009. Although the
maximum drawdowns were less than those of the S&P 500, an investor in an absolute return fund would hardly have been pleased with a 42% drawdown.
Market-neutral funds had a significantly lower drawdown, making them slightly more interesting for diversification purposes.

Source: FactorResearch

LIQUID ALTERNATIVES FROM A PORTFOLIO PERSPECTIVE

An investor currently concerned about high valuations, record levels of debt, and geopolitical instability might consider adding liquid alternatives to protect their
portfolio. We can simulate this on a historical basis by adding a 20% allocation of liquid alternatives to a portfolio consisting exclusively of the S&P 500 with
quarterly rebalancing.

In this case, the risk-return ratios would have improved in all three scenarios compared to the S&P 500 on a stand-alone basis, demonstrating the benefits of
diversification. However, adding an equivalent allocation to 10-year US Treasury bonds would have meant better risk-adjusted returns.

Source: FactorResearch

Similarly, the maximum drawdowns of the combined portfolios would have fallen only slightly and less than they would have with exposure to bonds. That means
liquid alternatives do not generate returns sufficiently uncorrelated to an equity portfolio. Put another way: They are not alternative enough.

Source: FactorResearch

FURTHER THOUGHTS

Liquid alternatives are useful investment products that give all sorts of investors access to typical hedge fund strategies and exert pressure on the hedge fund
industry to reduce its fees. But investors should be wary of liquid alternative funds that offer equity exposure at high fees and effectively represent fake
alternatives.

RELATED RESEARCH

Hedge Fund Factor Exposure & Alternatives

Factor ETFs & Futures

ABOUT THE AUTHOR

Nicolas Rabener is the founder & CEO of FactorResearch, which provides quantitative solutions for factor investing. Previously he
founded Jackdaw Capital, an award-winning quantitative investment manager focused on equity market neutral strategies. Before
that Nicolas worked at GIC (Government of Singapore Investment Corporation) in London focused on real estate investments
across the capital structure. He started his career working in investment banking at Citigroup in London and New York. Nicolas
holds a Master of Finance from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance
sports (100km Ultramarathon).

Connect with me on LinkedIn or Twitter.

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