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The Wrong Way to Use Liquid Alts

By Murray Coleman November 20, 2014

The stampede into liquid alternatives that has pumped more than $40 billion into mutual-fund and ETF coffers so far this year shows no signs of reversing course anytime soon. Yet advisors experienced in dealing with these strategies warn clients not to expect too much.

“A lot of people see liquid alternatives as some sort of magic formula that can both amp returns and dampen volatility, when in reality most of these funds are aiming at much less lofty goals,” says Will Braman, advisor and chief investment officer at Ballentine Partners in Waltham, Mass., which manages $5 billion.

With stocks at all-time highs, a common misconception is that liquid alts can lower an equity portfolio’s volatility while still producing market-beating returns. And with bond yields near historic lows, clients too often believe these funds can juice fixed-income returns while hedging against interest-rate risk. That’s mostly magical thinking, experts say, on the part of investors who don’t understand that liquid alts can’t deliver what a far less liquid and much more leveraged hedge fund delivers. Their main point is to add a little extra insurance to a portfolio when markets get rocky, not to seek outsize gains.

According to Morningstar, mutual-fund and ETF investors can choose from more than 500 funds employing 21 distinct non-traditional strategies. “With so many different funds on the market, we’re finding clients often ask for results that don’t always match what the funds are designed to produce,” says Mark Wilson, advisor and chief investment officer at the Tarbox Group in Newport Beach, Calif., with $450 million in AUM. “There are right ways and wrong ways to use these funds.”

The wrong way, he says, is to use liquid alts within a stock or bond allocation. Instead, he reduces both allocations equally to make room for a new alternatives bucket in the portfolio — which should contain no more than 10% of total assets, he says. Two funds Wilson favors are Natixis ASG Global Alternatives A (GAFAX) and the AQR Managed Futures Strategy N (AQMNX), both of which are aimed at hedging against volatility in both equity and fixed income.

When clients get overexcited about what such strategies can do, he likes to point out that their stock ETFs charge expense ratios of 0.15% on average. For bonds, he can mix traditional mutual funds and ETFs at a cost of about 0.3% per year. Wilson says, “The key question to ask someone asking for more liquid alts is, ‘Why should we use alternative funds at eight to 10 times the cost to replace what’s been working well so far?’”

That raises the question of why alternatives are necessary in the first place. For example, Wilson says, his team can manage interest-rate risk just fine over time by blending short- and long-term traditional bond ETFs. In stocks, market volatility can usually be managed with a closely monitored mix of long-only ETFs with different market-cap, sector and geographic tilts. “We let clients know that in choosing to use liquid alts, we’re not trying to fix something that isn’t broken,” he says. “These are complements to hedge our bets a little in case stocks and bonds don’t hold up as well if market volatility increases in the future.”

In fact, return data compiled for FA-IQ by Morningstar shows that over the past five- and 10-year periods, a portfolio of traditional funds holding more bonds than stocks has outperformed the liquid-alt category by a wide margin. “The truth of the matter is that a conservative allocation of bonds and cash can be just as effective on a risk-adjusted basis,” says Josh Charney, a Morningstar analyst.

Nevertheless, Alex Knapp, head of liquid alts research at Ballentine Partners, believes all clients should consider liquid alts — even those who can afford to invest in private hedge fund strategies. For ultra-HNW clients, he says the firm allocates 8% to 12% of total assets to a combination of the two. For clients with smaller portfolios, the alternatives allocation is lower, with everything in liquid alt mutual funds. “A lot of our clients like the fact that they’re less expensive to own,” Knapp says.