The Rise of Liquid Alternatives

Water FountainIt is no surprise that liquid alternative solutions are growing in popularity. They combine the benefits of daily liquidity and transparency with the enhanced capabilities of hedge fund strategies. However, the recent rise of liquid alternatives has also resulted in increased scrutiny, with some suggesting that their structure may result in compromised return potential, lower manager quality and limitations on trading strategies. These criticisms may, in some cases, be overstated—at the moment, plan sponsors continue to seek actively managed alternative solutions that deliver  diversification, capital preservation and asymmetric returns to achieve a specific investment goal across market cycles.

Hedge fund strategies provided through a liquid alternative solution have several advantages. Investors now have a way to tap into another alternative investment with different risk and return characteristics than equities and fixed income. Liquid alternatives also offer simple exposure to multiple types of hedging strategies at once—event driven, global macro, long-short equity and relative value.

The underlying structure provides investors with the flexibility, transparency, liquidity and pricing unavailable in traditional hedge funds.  Liquid alternatives also offer daily position-level transparency and daily liquidity, critical for risk monitoring and investment flexibility. There is also a flat fee structure of a managed account, instead of an incentive schedule used by typical hedge funds.

Evolution of active management

Liquid alternative solutions fit with the way investors’ views of active management are evolving. According to Russell Investments’ 2012 Global Survey on Alternative Investments, the most popular use of alternatives was to increase portfolio diversification, followed by managing volatility through strategies less correlated to equities and fixed income. Today, investors view actively managed products as a way to complement a passive or benchmarked core portfolio, achieve a specific investment outcome or take advantage of a market trend.

Hedge funds, and specifically liquid alternatives, have seen tremendous growth in recent years. Assets in hedge funds more than doubled to nearly US$3 trillion from 2005 to 2014 (HFR Industry Reports, January 21, 2015). At the same time, the level of U.S. assets in liquid alternative funds grew from less than US$50 billion to US$350 billion (Morningstar, 2015).

Hedge funds have historically exhibited better downside protection compared to Canadian equities during bear markets over the past 25 years. There have been periods where the Canadian equity market has lost more than 43% of its value, while the average hedge fund hasn’t lost more than 13% in any drawdown event (HFR Industry Reports, January 21, 2015).

Similarly, hedge funds have outperformed Canadian fixed income over the same period. Over the past 25 years, the average hedge fund earned a return nearly double (96% higher) that of the Canadian bond market, as measured by the HFRI Fund Weighted Composite versus the FTSE TMX Canada Universe Bond Index (HFR via FactSet, FTSE TMX via Morningstar Direct).

By combining these proven advantages of hedge fund strategies with the benefits of daily liquidity and transparency, liquid alternative will continue to be a fast-growing segment of the marketplace, whether as stand-alone solutions or as part of a portfolio alongside traditional investments.

Dan Elsberry is senior managing director and head of alternatives, K2 Advisors