Understanding The Key Landmines In Liquid Alternatives

A version of this first appeared in Absolute Return here

Investors are understandably frustrated with liquid alternatives. The average liquid alternative fund has underperformed its hedge fund brethren by around 200 bps per annum, which is meaningful when hedge funds themselves have been delivering mid-single digit returns. Further, funds have experienced unexpectedly large drawdowns – a left fat tail issue. As we survey the landscape, we see five key issues that have led to investor disappointment:

  1. Elevated return expectations.
  2. Returns chasing and persistence.
  3. High fees and the impact on expected returns and risk.
  4. Insufficient diversification.
  5. Asset-liability mismatches.

These five issues often are interrelated, which makes it difficult to pinpoint a single issue that has caused investors to re-examine the merits of the strategies. It also explains some of the confusion in the space. For allocators, a potential solution is to set realistic expectations, diversify, and carefully examine non-obvious risks.

  1. Elevated return expectations.

Regulated UCITS and mutual funds have far more constraints – liquidity of positions, leverage, diversification, etc. – than a typical hedge fund vehicle. In the multi-manager mutual fund space in the US, many firms underestimated the impact of these constraints on performance; most funds launched with great fanfare in 2012-14 have been closed after a run of low single digit returns (Blackstone is a standout). Alternative risk premia products looked great on paper but have failed to deliver in practice. Those products were often based on a theoretical expectation that was unlikely to be realized in practice.

  1. Returns chasing and persistence.

With moderate overall returns, the tendency has been for capital to flow disproportionately, benefiting recent outperformers. Given that a good fund in a given hedge fund category will outperform its struggling peers by 30% or more, at any given point there is a pool of single manager products coming off a hot streak. There is little evidence that performance streaks persist, and hence we have seen massive inflows into high-fliers that reverse quickly when performance wanes. A less obvious form of returns chasing relates to funds with illiquid assets: portfolios look more statistically stable (and hence less beta, more alpha), but shoulder potential left fat tail issues.

  1. High fees and the impact on expected returns and risk.

Fees matter, a lot. An equity market neutral fund with a 1/15 fee structure needs to generate 9% for investors to realize 6%; this is often unattainable without taking material risks through factor or other bets. Credit-focused funds gravitate into riskier and less liquid bonds and loans to deliver reasonable net returns when high grade and sovereign yields are low or negative. Therefore, high fees not only diminish long term returns, but often result in excessive risk-taking. Returns chasing may exacerbate the problem. For a fund on a hot streak, fees appear reasonable; when performance reverts to the mean, high fees mean most excess returns go to managers, not investors.

  1. Insufficient diversification.

The standard model among wealth managers has been to select one single manager fund per strategy. A typical portfolio with a 10% liquid alts allocation might have one fund in each of macro, equity market neutral, relative value and managed futures. Given dispersion, this is the equivalent to having, say, ten stocks in a small cap equity allocation – far too risky for a multi-asset portfolio. The end result has been that allocators have been playing defense when one or more single manager funds go through protracted drawdowns.

  1. Asset-liability mismatches.

Following several recent blow ups, investor attention has turned to the risk of a daily liquid fund that invests in illiquid assets. Illiquidity as a concept is complex: some assets trade regularly in good times, with no bids when markets deteriorate. Given where we are in the cycle, managers may have a huge incentive to load up on potentially illiquid assets in order to improve returns and worry about the consequences later. This risk is compounded by what we call the “hair trigger” problem: a fund with only 10% in truly illiquid assets must quickly throw up the gates when redemptions start in order to protect remaining investors. Expect this to be a serious issue for many funds over the coming years.

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There is no single solution to helping investors to build successful liquid alternatives portfolios, but we propose a few guideposts:

  1. Set realistic long-term expectations.

A related problem of returns chasing is that client expectations are set too high. It may be a warning sign, not a validation, if a fund has outperformed its peers by 500 bps over the past few years. The returns of the overall category should be the guidepost. For liquid alternatives, this can be problematic when many funds have relatively short track records; the solution, we believe, is to use more robust hedge fund data and then adjust it by strategy for any systemic performance drag. For instance, credit hedge funds with no liquidity constraints should meaningfully outperform mutual fund or UCITS funds over time, while managed futures or equity long/short hedge funds and regulated products should deliver comparable returns.

  1. Diversify single manager risk.

The simplest solution for the 10% allocation described above may be to include twenty, not four, single manager funds – what institutions do all the time. The practical hurdle is that model portfolios often only invest in one or two funds (or index products) per asset allocation bucket. As investors have come to appreciate single manager risk, we’ve seen a shift in attention back to multi-manager products (Abbey in managed futures in the US; Blackstone, K2 and now an index-like Aberdeen product in Europe). The issue with multi-manager products is high all-in fees – some close to 300 bps per annum. An alternative approach may be to use well-designed replication-based strategies, which can deliver diversification at low cost.

  1. Focus on expected returns rather than recent performance.

Managers should be able to articulate in detail how they expect to meet return targets. For an investor today, this is far more important than whether recent strong performance was due to luck or skill. The difficulty is that returns for many strategies appear to go through cycles, and often are dependent on the performance of traditional assets (e.g. equity long/short returns will be lower if overall equity returns decline), so return expectations are subject to numerous assumptions about market conditions.

  1. Understand the underlying portfolio today.

Allocators should focus on two risks: tail risk and liquidity. There arguably is no free lunch, so it is important to understand what non-obvious risks are in the portfolio. For instance, what factor loadings underpin an equity market neutral fund? How much have illiquid positions contributed to returns and suppression of volatility? How is liquidity calculated, and which positions that appear liquid today could cause problems in less sanguine markets?

  1. De-emphasize short term performance metrics.

Alternatives provide diversification over years, not necessarily months or day-to-day. We’ve seen a great deal of focus on short term correlations, which typically are noise given the instability of correlations across the markets. A better approach, we believe, is to think carefully through how and why the strategy should perform during extreme events – when alternatives potentially add the most value.

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In conclusion, investors have undertaken a healthy review of the liquid alts space. As is true when investing in complicated strategies, there is no magic bullet. The hurdle for allocators is to see through marketing material that invariably frames the narrative in the most positive light. A healthy skepticism is warranted, and we have tried to identify key areas of due diligence that might enable allocators to sidestep some of the landmines that became apparent over the past several years. As with many strategies, the most powerful tool may be diversification – none of us has a perfect crystal ball, so diversification across strategies and products can minimize near term risk and help allocators to meet long-term investment objectives.

October 4, 2019