Liquid Alternatives: Here’s What You Need To Know Before Investing

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January 28, 2023
3 Minute Read

What are Liquid Alternative Investments?

Colloquially known as Liquid Alts, Liquid Alternatives are a type of publicly-traded alternative investment.

These investments are publicly traded mutual funds and ETFs designed to be easily bought and sold; they offer either daily or weekly redemptions but are designed to replicate hedge fund strategies using a combination of financial instruments that will generate performance with a low correlation to traditional benchmarks.

Liquid Alts have a much lower minimum investment than your typical hedge fund, and investors do not have to pass net worth or income requirements to invest.

Quick History of Liquid Alts

These investment instruments were created after the 2008 financial crisis as a ‘hedge fund for the masses.’ Retail investors suffered, while ultra-wealthy hedge fund clients scored enormous profits during that time.

However, Liquid alts failed to live up to their hype in the next decade.

During the massive bull market of the 2010s, liquid alternatives performed terribly. According to Morningstar, liquid alts averaged 1.66% annualized returns, placing them behind nearly every fund category.

Not surprisingly, this underperformance initiated massive outflows between 2015 and 2020. But as market volatility rose in 2021 and 2022, liquid alts saw net inflows as investors looked to shield themselves from market gyrations.

How Do They Work?

Liquid Alternatives aim to replicate many hedge-fund-like strategies through publicly-traded instruments like equities, fixed income, currencies, futures, options, and commodities.

And while most instruments are generally liquid investments, liquid alts can hold 15% of their investment in illiquid securities like variance swaps or OTC options.

Liquid Alternative Strategies

There are a wide variety of strategies deployed by Liquid Alternative mutual funds and ETFs, but generally speaking, they can be bucketed into 3 groups; Return Enhancers, Diversifiers, and Volatility Reducers.

Return Enhancers

Provide returns that are correlated with the market but have the potential to exceed the market benchmarks.

  • Event Driven strategies seek to exploit pricing inefficiencies that may occur before or after a corporate event, like a merger, acquisition, earnings call, bankruptcy acquisition, or spinoff. More recently, event-driven strategies have included natural disasters and actions initiated by shareholder activists.

Diversifiers

This strategy aims to provide different sources of returns to always generate a positive return no matter what the market is doing. Examples of diversified strategies include market-neutral funds and relative value.

  • Market Neutral strategies seek to generate positive returns independent of upward or downward trends in the market through a combination of long and short strategies.

  • Relative Value strategies seek to generate returns through price differences between related financial instruments, for example, the difference between oil futures contracts and gasoline prices.

Volatility Reducers

Volatility Reduction strategies have a low-to-negative correlation to the market with the potential to provide returns during market duress.

  • Managed Futures are alternative investments that consist of a portfolio of futures contracts. Managed futures bet on or against trends in stocks, currencies, interest rates, or commodities. They typically employ a market-neutral strategy or a trend-following strategy.

What You Should Know About Liquid Alts

At the face of it, deploying a hedge fund-like strategy with daily liquidity sounds perfect for retail investors, right?

However, there are some key considerations you need to be aware of before investing in liquid alts.

Low Correlation. Some liquid alts strategies, like market natural strategies, can provide non-correlated returns to the overall market, thus providing a good way for retail investors to add diversification to their investment portfolio.

Higher Fees. The average expense ratio for liquid alternatives is 1.66%, compared to 1.40% for mutual funds and 0.40% for ETFs. While a 0.26% difference over mutual funds may not seem like a lot, compounded over many years, it can eat into your profits.

However, funds and liquid alt fees have been dropping over the past few years. For example, the largest liquid alt by AUM, the JPMorgan Hedged Equity fund, charges just 0.85%, nearly half the industry average.

Imperfect Replication. Because liquid alternatives are subject to the 1940 investment Act (Act 40), they are more limited in their investment options than traditional hedge fund peers.

Limited Leverage. Liquid alts cannot employ leverage as effectively as their non-40 Act peers. The 40 Act limits the use of leverage to 33% of the gross asset value of the fund, whereas hedge funds have no leverage limit.

Shorting. The rules of the 40 Act limit how much shorting can be done. As a result, many of the strategies that are most beneficial for diversification purposes cannot be effectively executed by liquid alts.

Liquidity. There is value in illiquidity, a benefit offered by traditional alternatives. Investors often understand and expect that by giving up daily liquidity, they should be rewarded with better returns.

The 40 Act limits the ability of liquid alternative funds to invest in illiquid securities. A 40 Act fund is mandated to maintain 85% of its portfolio in liquid assets.

Can be hard to understand. These funds and ETFs may use exotic financial instruments, variance swaps, options and VIX futures, as noted by Morningstar. This can make liquid alts challenging to understand for everyday investors.

Liquid Alternatives ETFs & Mutual Funds

There are over 100 liquid alternative funds deploying various strategies. Below are some of the largest Liquid Alternative Funds according to Barrons:

  1. JPMorgan Hedged Equity / JHQAX

  2. Calamos Market Neutral Income / CVSIX

  3. Gateway / GATEX

  4. BlackRock Event Driven Equity / BALPX

  5. Blackstone Alternative Multi-Strategy / BXMIX

  6. Neuberger Berman Long Short / NLSAX

  7. BlackRock Systematic Multi-Strategy / BAMBX

Are Liquid Alternatives Worth It?

Liquid alternatives could be an appropriate investment during unfavorable market conditions. Still, they should generally not be a useful tool during a rising market, as indicated by their poor performance during the 2010s.

Real World Investor

Adam

Adam is the founder of realworldinvestor.com, an investing website dedicated to helping discerning individuals make the best investment decisions.

Before starting Real World Investor, he was a Senior Vice President at one of the country's largest investment banks. He has over 10 years of experience working in financial services. His experience includes working with complex derivatives while spending many years working on a trading floor.

He has a bachelor's degree in Business Administration, majoring in finance.