The Outlook for Liquid Alternatives in 2015

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Expert Analysis and Commentary

The Outlook for Liquid Alternatives in 2015

Justin Frankel Jan 14, 2015

As 2015 begins, there are over 500 registered alternative strategy mutual funds with over a combined $300 billion in assets under management. This is up from just over 400 funds and $264 billion a year ago. It’s likely that this increase in terms of AUM would have been greater had the strength of the equity markets wavered, but even in the face of another strong year for stocks with little volatility, the demand for non-correlated strategies continues to grow.
There are some signs that 2015 will be an even stronger year for the industry, and much of it has to do with how the macro-environment may change. Faced with an aging bull market, the potential for rising interest rates, and increased equity volatility, investors are beginning to question what their next moves will be. They may find their answers in the Liquid Alternatives space.

New Launches for 2015

Whether through the conversion of traditional partnership hedge fund structures into mutual funds or through an expansion by well-known hedge fund managers into the liquid alts space, 2015 should see a continuation of the trend for new launches. In either case, asset flows from individual investors will be the main driver of this trend. Raising money in hedge funds continues to be a challenging endeavor for all but the biggest funds, and most hedge funds are not effective at marketing to individual investors and RIAs. It is this segment of the market that has the biggest growth potential in terms of using alternatives, and managers are beginning to realize that a mutual fund vehicle can help them tap into this under-served market segment.

Investing in hedge funds involves a lot of due diligence, and smaller investors and the advisors with whom they work are often not prepared to conduct the thorough examination of managers and strategies that is necessary when introducing an alternative strategy into the portfolio. The knowledge gap between this potential investor base the providers of the strategies has been one of many high barriers to entry for these investors, and the mutual fund wrapper helps to bridge this gap. The mutual fund vehicle offers transparency, scalability, and liquidity that partnership structures cannot, while adding the comfort and standardization of disclosures inherent in the regulatory oversight of a ’40 Act product.

Investors to See More Choice

As more managers enter the marketplace, investors will also benefit from an increase in the diversity of choices they will have. Investors will see a greater ability to finely tune their portfolios in terms of risk and return, allowing them to construct portfolios with specific allocations to the attributes of volatility, yield, momentum or other factors that they desire. Giving investors the power to dial up (or down) risk and return characteristics will allow for more customized portfolios, making it easier for people and their advisors to address specific investing goals. The access that the average investor will gain to these new investments is unprecedented, but also carries with it new risks.

No conversation about liquid alternatives would be complete without highlighting the risks that investors must understand prior to making an investment in one of these funds. While there are regulations that govern liquidity, diversification, and leverage within these Liquid Alt funds, investors still need to understand clearly how their money is being invested by the managers of these funds.

Investor Responsibility for Liquid Alts

Beyond evaluating the type of strategy being used, investors also need to question the track record, specifically how a fund behaved at certain points in time. Essentially, investors and advisors need to get comfortable with expected results for specific scenarios. It is only once this type of evaluation is done that a liquid alternative fund can be effectively used. Investors should also remain aware of expenses. These can come in the form of expense ratios, sales loads, or tax implications, and can impact performance. While some expenses may look high when compared to ETFs, index funds, or traditional long-only mutual funds, investors must understands that Liquid Alts are different from those products. The question should not be about price, but about relative value. For example, if the fund is designed to reduce correlation and provide a hedge, comparing it on price alone to an index fund may not be appropriate.

When it comes to assessing the benefits and risk of a Liquid Alt fund, the responsibility doesn’t rest solely on the investors. As managers, we need to communicate the material details of our strategies efficiently, clearly and regularly. We need to do a better job understanding how our strategies are being used by investors and advisors in order to position ourselves as a solutions provider for them.

The Bottom Line

2015 is positioned to be a great year for the liquid alternatives industry. Despite a market environment that hasn’t rewarded hedging strategies for the past two years, Liquid Alts have managed to gain a larger portion of both investor ‘mind share’ and ‘wallet share’. As market conditions change, interest and adoption of these investments should only accelerate.

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