Liquid alternatives have suffered from performance and perception problems, severely lagging the hedge funds they were based on – but, Elizabeth Pfeuti hears, the market environment could start to favour them.
Game-changers don’t always find their moment the first time around.
The first electric car was designed and built in the US before the turn of the 20th century, but it has taken more than 100 years for it even to begin to take over from its fossil-fuelled rival.
In a more truncated history, liquid alternative products, which looked primed and ready to assume the dominance of traditional hedge funds after the financial crisis, have also failed to take the lead.
While sticking with the investment ideas created by their physically backed cousins, the strategies offered to track the risk premia driving them, rather than buying the securities themselves. This was intended to play on investor concerns of being trapped in poorly performing funds – and paying a fee to do so.
But instead of capitalising on the fear and loathing from previously disappointed and gated hedge fund investors, in 2019 Preqin predicted hedge fund assets would reach $4.7 trillion by 2023 – a full 40% increase on their pre-crisis total.
So, still boasting only billions of dollars in assets, have liquid alternatives missed their big moment?
For James de Bunsen, portfolio manager in the UK-based multi-asset team at Janus Henderson, three main problems have plagued the sector.
One is inconsistent performance. While “not entirely surprising given the heterogeneity of the sector in terms of strategy and risk profile”, the sector was not helped by some “unsustainable performance targets”, says de Bunsen, adding that there has been some “questionable” marketing.
The lack of diversification in investors’ portfolios has also been a problem, as “many investors seemed to believe that holding one liquid alternatives fund was sufficient to add some diversification to their portfolios”. An additional effect of this was that the underperformance of one fund was thought to be representative of the sector, which was neither true nor fair.
De Bunsen’s third reason is quantitative easing, which has led to low volatility at both an asset class and an intra-asset class level. “There is valuation dispersion within equities and fixed income, but the problem for relative value managers is that this dispersion appears entrenched,” he says.
Of the three, performance has been the major issue, with 2018 a pretty torturous year for the sector. While in 2018 global equities posted their worst year since the financial crisis and many bonds offered negative yields, performance by liquid alternative strategies was largely down, too, thereby failing on the specific promise of downside protection and positive absolute returns.
Joan Lee, senior portfolio manager at Unigestion, says this had forced some providers to scale back offerings in the past year, trimming poor performers and non-diversifiers.
Raphael Haselberger, senior product specialist at Allianz Global Investors (AGI), understands investor frustrations and has an explanation.
“We believe the negative performance was due to a confluence of specific circumstances that are unlikely to be repeated in the future,” he says. “We also think it is important to bear in mind that liquid alternative strategies do carry certain risks – which ultimately are the source of attractive returns over the long run – and a negative year like 2018 is within the investment mandate for most of these strategies.”
‘Not unusual’
However, Vitali Kalesnik, director of research at Research Affiliates, says the drawdowns in 2018 should not be seen as unusual.
“This is quite typical of the factor premia that liquid alt funds are trying to harvest,” he says. Understanding how these factor premia act – and how long investors will have to wait for performance – is key to investing in liquid alternatives.
“These premia are in part a compensation for investors willing to be patient and to take the risk of periodic uncomfortable drawdowns,” Kalesnik adds. “It is worth noting that, in general, performance has rebounded in 2019 for many strategies, including our own.”
AGI’s Haselberger adds that most of its strategies have also made back the losses from 2018 and are above their prior high-water marks.
So, could this serve to hasten the sector’s Tesla moment? Not so fast. As the world’s most famous electric car manufacturer has found, performance is key, but so is price. Getting one right without the other is not going to bring success.
Bobby Blue, manager research analyst at Morningstar, explains why some investors were disappointed.
“Many of these products were launched as a mutual fund vehicle of an existing hedge fund strategy, which often leads to sacrifices to meet the regulatory requirements of the mutual fund format,” he says. “This can water down some of the benefits of the hedge fund strategy and decrease the return potential of the fund.”
While fees are often slightly lower than in a traditional hedge fund, managers still charge a premium and have discovered that investors are not keen on paying for underperformance.
And even if there has been some performance upticks for liquid alternatives, investors should be aware that each strategy has its own characteristic and will act differently according to scenarios.
Morningstar found some strategy types, including event-driven funds, saw success in a good environment for mergers and acquisitions at the end of 2018, while rising rates and volatility have helped performances, too. But this has not worked across the board – which is ultimately the point of these funds.
Combined with performance issues, Blue has noticed that assets are not as sticky in liquid alternatives products as traditional ones – the clue is in the name – but this creates a specific market anomaly.
“There seems to be a winner-takes-all approach where strong-performing funds receive an outsized percent of the flows into the space,” he says. “And then, just as quickly, when things start to look bad, investors storm out.”
This can partly be attributed to a lack of understanding, Blue adds. “If you’re buying into a fund because it’s doing well, you might not fully understand what’s driving that performance, which can lead you to exit when that fund hits a rough patch, even if that’s expected as part of the fund’s process.”
But if you do understand what you’re getting into, then liquid alternatives could be a winning strategy in the current low interest rate environment, which looks set to stay around for some time yet.
“In the environment when the major asset classes are priced for close to zero or negative performance, investors are eager to look for any other potential for outperformance,” says Kalesnik. “Liquid alternatives are supposedly not highly correlated with other major asset classes and are priced at an advantage to hedge funds in terms of management fees.”
To be, or not to be
For de Bunsen at Janus Henderson, the appeal of these strategies may be as much based on what they are not – i.e. equities and bonds reaching the very top end of valuations – as to what they are.
“Investors have been punished for straying into more cyclically sensitive areas and cash yields nothing,” he says. “So, liquid alternatives at least hold the promise of positive real returns, often low correlation to equities and no duration risk.”
Haselberger at AGI agrees that in the context of moving away from highly valued mainstream asset classes, liquid alternative strategies “can play an important role in building robust, diversified portfolios fit to withstand stress scenarios and at the same time enhancing the portfolio’s risk/return profile”.
Kerrin Rosenberg, chief executive officer of Cardano, has seen liquid alternatives’ failure to launch, too, but has identified a silver lining.
“Over the past few years, performance concerns and the trend towards cheaper, passive solutions have driven outflows from these strategies,” he says. “However, this reduction in assets under management has been a net positive, enabling managers to be nimble and better equipped to exploit opportunities.”
De Bunsen at Janus Henderson adds that despite the issues with the sector – and its failure to secure favour with investors – “fund launches continue apace, bringing some fantastic managers to the regulated sector, with competitive fee structures, who have managed to deliver in terms of performance and low correlation”.
At Unigestion, Lee cites some promising figures from an October EQDerivatives survey for the sector, estimating that the total alternative risk premia market was worth $60 billion, having grown 22% in the past year.
The market is expected to grow by another 25% or $15 billion in the next 18 months, according to the survey. It’s no $4.7 trillion predicted for hedge funds, but might the sector be finally on its way?
“In hindsight, these outflows [as a result of 2018 performance] came at a time when conditions for liquid alternatives became more constructive and performance rebounded,” says Haselberger, urging investors to take a long-term view.
While it may yet be too early to herald the successor of the traditional alternative fund, we could be about to witness liquid alternatives’ permanent arrival, a few years shy of Tesla’s century.
©2019 funds europe
