Liquid "alternative" investment strategies have been among the most popular but least understood investment innovations of recent years. Liquid alternatives burst upon the scene in 1997, after an obscure but important rule governing mutual funds—the short-short or 30% rule—was repealed as part of Bill Clinton's Taxpayer Relief Act of 1997. Repeal of the rule made it more practical for mutual funds to engage in short-term trading and short selling, ultimately opening the floodgates for mutual fund and ETF strategies that emulate hedge funds.
In the last three years, alternative mutual funds and ETFs have gathered $60 billion of assets, and the category as loosely defined by Morningstar has reached $120 billion in assets.
Wealthy investors and endowments historically have invested in hedge funds to enhance returns or to reduce portfolio risk. In recent years, Yale's success investing in hedge funds and private equity has influenced the investment strategies of many advisors, while individual investors have been drawn to the eye-popping returns of the hedge funds that were big winners before or after the financial crisis.
Interest in hedge funds that provide downside protection is also a natural response to the financial crisis, as traditional investments thought to provide diversification failed to protect portfolios during the bear market. Consequently, individual investors have wanted a way to participate in the action, and increasingly are turning to liquid alternatives as the vehicle to do so. Previously, individuals have used liquid vehicles to follow their institutional counterparts in formerly exotic investments such as real estate, emerging markets equities and commodities; liquid alternatives are the next chapter in that story.
The benefits of liquid alternatives in comparison with traditional hedge funds are compelling. Liquid alternatives, whether in mutual fund or ETF form, provide easy and low-cost access to traditional hedge fund strategies. Liquid alternatives offer daily liquidity, have low minimum investment requirements, and provide more investment transparency and regulation than traditional hedge funds.
As Rick Lake of Lake Partners puts it, liquid alternatives provide a "kinder and gentler" way to invest in hedge funds.
What Are Liquid Alts?
Liquid alternatives cover a wide range of investment strategies that don't fit neatly into a single classification. Morningstar defines alternatives as investments that fall into one of three categories:
- Non-traditional asset classes, such as futures and currencies.
- Non-traditional strategies, such as short selling or hedging.
- Illiquid assets, such as private equity, private debt or distressed debt.
Some strategies aim to be fixed income alternatives by providing bond-like returns and risk, while other strategies are more equity-like from a risk-return perspective. It's important to understand the objective for each alternative investment strategy, and to understand the approach taken to achieve the objective.
In our view, the primary alternative strategies are long-short equity, event-driven, long-short bond, and macro.
The remainder of part one of this column will review long-short equity strategies and event-driven strategies.
Long-Short Equity Strategies