Do's and Don'ts for Employing Liquid Alternatives
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Although alternative strategies have been around for years, liquid alts are relatively new. What do advisors need to know about them?
The transition from accessing alternative strategies via hedge funds to accessing them via mutual funds can be more challenging than most advisors initially perceive. Issues can arise if advisors mistakenly assume that the risk and reward potential of a given strategy is the same regardless of the vehicle used to access it.
Due diligence requirements don’t simply vanish because an alt strategy is now available in a more liquid form. To be sure, the '40 Act funds are more heavily regulated vehicles and are typically offered by large, well-established fund companies. However, most of these strategies were launched after 2008 and so have a limited live track record. Therefore, advisors really do need to perform a deep dive to ensure that they understand how the strategies should perform over a full market cycle.
Another potential challenge for advisors: maintaining realistic expectations of returns from a liquid alt strategy. Limited partnership funds are less constrained with respect to leverage and illiquidity than is a mutual fund version of an alt strategy. That means a well-run limited partnership fund should outperform a well-run mutual fund over a full market cycle (assuming that leverage and illiquidity are positive performance drivers for a well-run strategy).
The flip side is that some alternative strategies lend themselves to the mutual fund structure better than others. For strategies that rely on leverage to drive performance, the universe of mutual funds that can deliver the goods is pretty limited.
One issue that comes up is client education. The “alternative” category is a misleadingly simple term to describe a wide range of financial instruments — anything from short securities to long commodities to derivatives. Some clients think all alternatives are high-risk. But whereas alts like commodities do exhibit higher volatility than core stocks and bonds, correlations with traditional portfolios are low, so they function as a diversifier. Meanwhile, negative-duration credit products reduce interest-rate risk relative to core fixed income. Used appropriately, alternatives can actually reduce portfolio risk and provide a benefit to clients who understand them.
Investors should hold alternatives for a full market cycle of three to five years. Clients who don’t understand the dynamics of the alts in their portfolio may insist on selling at the wrong times, putting themselves at a huge performance disadvantage. For instance, long/short equity strategies will lag the broader equity market during rallies. Meanwhile, arbitrage strategies have very low volatility and low correlation to traditional stocks and bonds, providing strong downside protection during market declines.
Another caveat: Just because an alternative strategy is now available in mutual fund form, that doesn’t mean advisors know how to use it. Many advisors are unfamiliar with alt strategies in general. Too small an allocation won’t help the portfolio; too large an allocation can have a range of negative effects. Adding absolute-return and other low-volatility strategies may reduce a portfolio’s return potential below acceptable levels, while adding commodities and other high-volatility alts may increase risk too much.
Once an advisor decides to use alternatives in a portfolio, the positions must be monitored on an ongoing basis. Daily volatility can be quite high. The advisor must ensure that the alternatives continue to fill their ordained role in the portfolio.