Magazine Issues » April 2019

Liquid alternatives: Digging deep for returns

Digging_for_alternativesDuring a decade of ultra-low interest rates, liquid alternative funds have become the fastest-growing asset class in Europe and the UK. But, asks Mark Latham, will the growth continue as rates begin to rise?

Liquid open-ended alternative funds, or liquid alts, have become the fastest-growing asset classes in the UK and European-domiciled cross-border fund market since the global financial crisis.

Morningstar’s Cross-Border Liquid Alternative Fund Landscape 2019 study, published last month, found that the number of funds has risen by 76% over the past ten years to 2,663 funds. Meanwhile, assets in such funds increased tenfold over the decade to €420 billion.

In addition, the report found, demand from European investors for these funds now exceeds interest in the US mutual fund market, where investors’ regard for the fund type started to diminish in 2016. This was down to the lacklustre performance of alternative products, along with rising interest rates in the US, which gave investors a better yield from bonds.

As a result, sales of liquid alts in the US fell 90% between 2013 and 2017, from net inflows of $53 billion to just $6 billion.

Matias Möttölä, Morningstar’s associate director for multi-asset and alternatives, believes that the growth of hedge fund-type strategies in a more liquid format in Europe has been fuelled by the low bond yields of recent years, combined with favourable regulatory changes and “vibrant” product development.

However, he adds, “the liquid alternative funds universe is mostly filled with young, untested strategies with a low asset base, and high fees in relation to the returns delivered so far, which represents a challenge for fund selectors. Overall, investors need to be mindful that despite the large inflows, this space is still in growth mode and far from mature.”

Karim Leguel, managing director at JP Morgan Alternative Asset Management, says that as the market moves into a late cycle – usually marked by increased volatility and uncertainty – his firm has seen a spike in interest for liquid alternatives strategies, “as investors seek out uncorrelated solutions to diversify their exposure to traditional equity and fixed income investments”.

He adds: “Despite liquid alternatives being a more recent development, the universe of experienced managers is expanding through direct offerings, but also through newer structures such as multi-manager funds, which use managed accounts to give clients exposure to a differentiated and wider universe of strategies and managers.”

The theme is taken up by Nathanael Benzaken, chief client officer at Lyxor Asset Management, who believes that the fact that the market is at the end of its cycle means that investors will continue to seek diversification, and so demand will hold up for liquid alternatives. “We are towards the end of a pretty long bull market and nobody knows whether the market will continue to go up,” he says.

“However, it is a reasonable assumption to say that there is going to be more asymmetry in terms of the upside and even if the market goes sideways, you are going to have more volatility.”

Benzaken also casts doubt on whether rising interest rates would dampen demand for liquid alts. “It is a tricky question – but as a principle, the higher interest rates are, the better the performance of hedge funds. Liquid alts are an attractive option if you want to diversify.”

Lizzy Buss, head of business development for State Street’s managed accounts business InfraHedge, says that the abilities to hedge, leverage and capture new sources of alpha are the main reasons for creating alternative Ucits funds. The rising interest rates environment, however, has “strong potential” to impact supply and demand for alternative Ucits funds.

Nevertheless, she says, “the reasons for creating an alternative Ucits remain, so I believe there will continue to be appetite. But yes, I believe appetite will be impacted by rising interest rates.”

Alternative Ucits funds can take a relatively long time to market, whereas interest rates can change overnight.Buss warns that this could lead to “drag”, adding: “This impact of one on the other will need to be considered in conjunction with this time lag, when looking at the correlation between the two.”

Brexit’s final outcome will also impact the sector, she says. “Alternative Ucits funds have the unique ability to distribute hedge fund strategies to retail clients within EU states and a major change in the composition of the EU, in addition to the ramifications of any final trade agreements, has high potential to disrupt this.”

Product development in the liquid alts area took a step forward recently when Aberdeen Standard Investments (ASI) launched a passive fund that tracks hedge funds.

Russell Barlow, global head of alternative investment strategies at the firm, says the fund launched in February is “unique”. Interest is reflected by assets, which have reached more than $200 million (€177 million).

The ASI HFRI-I Liquid Alternative Fund tracks an index, compiled by US-based Hedge Fund Research, of around 140 Europe-domiciled hedge funds with aggregate assets of more than $110 billion.

Barlow claims that, despite the proliferation of tracker products that cover traditional asset classes, ASI’s Ucits fund is the first passive investment product to provide exposure to “the return and diversification benefits” of hedge funds.

He says: “It is indicative of the opportunity set to provide clients with a vehicle that can meet some of their needs within this area, It is a different product from what has been offered in the past. “

He adds there is not currently a viable passive option that can generate a benchmark return in the same way.

“Everybody is very comfortable with the concept of the S&P 500 as a benchmark and there is a lot of product out there that can generate or deliver the return of the S&P 500 by physically replicating it.

“Now we have the industry’s first tracker fund that is actually physically investing in the underlying holdings of the index and the irony is, for all the complexity in the hedge fund arena, this has never existed before.”

Nobody, he adds, has ever used an independent asset manager and an independent index provider to come up with a “credible” universe of funds.

The product currently has around 150 funds in the index and ASI expects that to grow to possibly over 200 by the summer.

Olivier Marion, senior investment specialist for alternatives for the Swiss bank UBP, says that the growth of liquid alts over the past decade largely stems from European hedge fund investors who were keen to have more governance, risk control, transparency and liquidity

“All of these requirements were put in place very successfully following the global financial crisis and we can now say that Ucits has become the standard format when it comes to liquid alternatives,” he adds. fe he adds.

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