Consider the Alternatives (Part 4)

What are liquid alternatives?

Lobate ctenophore, a deep-sea animal. Photo: Marsh Youngbluth. Source: NOAA

Liquid alternatives are alternative investment strategies that are available through conventional investment vehicles, like mutual funds and ETFs. They’re provided for investors who are looking for the diversification of alternatives but want more liquidity than hedge funds, private equity, or direct ownership of alternative assets can provide. Typically, they’re oriented around a hedge-fund like strategy, like using futures contracts to short the equity market while buying stocks that could do better than the market.

These funds typically use financial formulas to simulate what an unconstrained hedge-fund investor might do. Some financial advisors recommend that up to 20% of an investor’s portfolio be dedicated to these funds. After all, global bond yields are at or near record lows, and the stock market is flirting with record high levels. With liquid-alt funds promising returns around 7-8%, what’s not to like?

The problem comes in the way that these funds generate returns. Because most mutual funds don’t actually short stocks or borrow money, many liquid alt funds use derivative contracts and hedging strategies. These work fine in theory—when everything is running well and everyone performs on their commitments. But things don’t always work out according to plan. Counterparties fail; contracts can be deemed unenforceable; operational issues can overwhelm a theoretically sound framework.

Mini Moke—works well in theory. Photo: Bryn Pinzgaur. Source: Car Pictures

By some measures, there are now over $2 trillion dollars in liquid-alternative strategies. That of course includes some genuinely liquid investments, like ETFs that use futures contracts to follow commodities like gold and oil. But it also includes funds that try to replicate the returns of unconstrained hedge funds. They try to use the actuarial averages of having lots investors to “create” liquidity in a set of essentially illiquid investments. The theory is, if enough people are engaged, a liquid-alt fund can be like a bank with checking account. When one person pulls out, another comes in.

This approach has several issues: first, the price indices used to value this kind of fund are, at best, estimates of where the true value lies. Any mispricing will favor either buyers or sellers. Sometimes we see indices of illiquid instruments get manipulated—for just this purpose. Second, administration of exotic funds like this is expensive. So the fees are high. If they are too high, the cost of diversifying may outweigh the benefits. Finally, synthesizing liquidity by having lots of investors is risky. If something shakes investor confidence and a large percentage of them pull out at the same time, forced sales will hurt performance—which could trigger more redemptions, and more forced sales. This is the liquid-alt equivalent of a bank run.

Bank run, 1931. Photo: Georg Pahl. Source: Wikipedia, German Federal Archive

You can’t make a silk purse out of a sow’s ear, and you can’t make illiquid investments liquid by putting them into a mutual fund structure and slapping a fancy name on them. This kind of strategy works until it doesn’t. And when it doesn’t work, it really doesn’t.

Douglas R. Tengdin, CFA

Chief Investment Officer

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