When the curtain came down on 2014, liquid alternative funds surprised a lot of people by outperforming hedge funds, their more experienced, more glamorous alternative investment cousins. After all, the reasoning goes, liquid alts are more constrained than hedge funds, so they should underperform.
I disagree. The fact is that the competitive landscape has changed. Since 2008, a subtle shift has taken place among traditional hedge fund managers. Many now use less leverage, as little as 2:1, and many are investing in more liquid securities.
In other words, many traditional hedge funds are beginning to look more like liquid alt funds. If imitation is the sincerest form of flattery, then hedge funds are acknowledging that liquid alts may be onto something. One big difference remains—the traditional hedge fund typically charges 2-and-20% in management and performance fees.
Liquid alts were designed to appeal to retail investors who want the potential of hedge fund-like performance without hedge funds' famous appetite for risk. In general, liquid alts are more transparent, use less leverage and, importantly, offer daily or weekly liquidity.
Those added features are supposed to come at a cost—which makes sense. After all, if there is one investing truism, it is "the greater the risk, the greater the (potential) return." It was no surprise, then, that a 2013 study found returns for liquid alts on average trailed hedge funds by approximately 1% annually. The study predicted that the 1% trade-off would be seen as a "reasonable price to pay for enhanced liquidity."
But in 2014, investors did not have to make that trade-off. According to Wilshire Associates, its Wilshire Liquid Alternative Index gained 1.55% in 2014, while a benchmark of hedge fund performance, the HFRX Global Hedge Fund Index, posted a negative 0.58%. It was the same story for the other five strategies in Wilshire's liquid alternative index. Each liquid alternative strategy beat its hedge fund counterpart. (See table on next page.)
Less risky and better performing? It sounds like a beer commercial. The reasons for outperformance varied from strategy to strategy. The relative value and event-driven classes, which are mostly invested in debt instruments, outperformed their hedge fund index counterparts by the biggest margins. That gap likely stemmed from the fact that liquid alts were invested in more senior, less risky debt instruments than were traditional hedge funds. In other words, the more aggressively hedge fund managers tried to hedge against bonds, the more likely their performance suffered. Event-driven hedge funds likely suffered from events—mergers, acquisitions and the like—that failed to occur.
