by wealthmanagement.com
Liquid alternatives are broadly defined as strategies that are available in registered funds (mutual funds, ETFs and UCITs) that seek to provide investors with diversification benefits and downside protection. Following the crisis, liquid alternative funds grew rapidly as more allocators sought to introduce sophisticated portfolio construction methodologies across retail and other portfolios. In recent years however, growth has slowed as many early adopters expressed frustration that performance had failed to match expectations.
Problems with Generation One Liquid Alternatives
Generation One products came in two general flavors: multimanager products designed to be “one-stop” solutions for the bucket, and single manager products akin to individual hedge funds. There have been three primary issues with these products.
1. Structural Underperformance of Some Liquid Alts Relative to Hedge Funds
Multimanager vehicles were built to appeal to asset allocators as a one-stop solution designed to match or outperform the “bucket.” While multimanager funds offered potential diversification akin to a portfolio of hedge funds, they suffered from two issues: poor net-of-fee performance and particularly high fees. Over the past five years multimanager mutual funds returned 1.9 percent per annum, or slightly more than half the 3.4 percent delivered by funds of hedge funds.1 Consequently, the funds underperformed despite a modest advantage on fees.
2. Fees That Are “Low Relative to Hedge Funds” Can Still Be Prohibitively Expensive
Hedge funds fees have taken center stage recently.2 Many Generation One products were designed with the pitch that, “if it’s cheaper than hedge funds at 2/20, it’s a great deal.” Multimanager mutual fund marketing material often highlighted the fact that fees and expenses were “half” those of funds of hedge funds.
When the average multimanager mutual fund has returned 1.9 percent, a 2.6 percent expense ratio means that nearly six of every 10 dollars made by the fund were paid away in fees — a worse ratio than for most hedge funds.
3. Dispersion of Single Manager Funds
The first generation of liquid alternatives products solved the “access and liquidity” issues. However, there were far fewer options than among hedge funds themselves, and the fund selection team would typically select a single liquid alternative fund to fill the bucket as shown below. Selection of a single fund failed to address the dispersion issue in hedge fund strategies. In a performance comparison of 36 equity long/short mutual funds over the past five years, the spread between the top and bottom performer was 154 percent.
Conclusion
Given the issues with Generation One products, Generation Two should satisfy three criteria for allocators:
1. Performance: Match or outperform a hedge fund index — especially no structural underperformance.
2. Cost: Have a low all-in fee structure that is comparable to traditional funds and attractive to fiduciaries.
3. Consistency: Deliver consistent results akin to those of a highly diversified portfolio of alternative managers.
In the second part of this series, we’ll discuss the asset allocation process and where Generation Two fits into this process. Furthermore, we’ll establish why a replication-based approach is especially well-suited to satisfy the needs of allocators within the Generation Two framework.
Andrew Beer