Understanding Liquid Alternatives

Liquid alternatives, also known as liquid alts, are investment products that offer diversification and downside protection through exposure to alternative strategies, presented in the form of mutual funds or exchange-traded funds (ETFs). One distinctive feature of liquid alts is their liquidity, allowing investors to trade them daily, unlike traditional alternatives that may only offer monthly or quarterly liquidity. Additionally, liquid alts have lower minimum investment requirements compared to standard hedge funds, making them more accessible to a wider range of investors, without the need to meet stringent net-worth or income criteria.

Despite their advantages, critics raise concerns about the long-term sustainability of liquid alts’ liquidity during challenging market conditions. These investment vehicles gained popularity post-financial crisis due to their potential benefits, yet critics argue that the fees associated with liquid alternatives are high. However, proponents view liquid alts as an innovative tool that democratizes hedge fund strategies, making them available to retail investors.

What Are Liquid Alternatives?

Liquid alts aim to address the limitations of traditional alternative investments by providing investors with daily redemption features, akin to mutual funds. Alternative investments encompass diverse assets like fine art, private equity, derivatives, commodities, real estate, distressed debt, and hedge funds, all characterized by their limited liquidity compared to conventional stocks and bonds. Liquidity in liquid alts allows for easier trading and mitigates lock-up periods and difficulties associated with smaller position sizes.

Criticism of Liquid Alternatives

The proliferation of liquid alternative funds post-2007 financial crisis reflects investors’ interest in hedge fund-like strategies for risk mitigation. However, the market has experienced closures and consolidations, leading to slowed growth and asset fluctuations. Critics highlight the higher fees charged by liquid alts compared to traditional mutual funds and the potential risks of packaging illiquid assets as liquid investments. The easy access to trade liquid alts, although appealing to investors, could pose challenges during market downturns.

Notably, critics caution that rapid withdrawals during market stress may force liquid alt providers to sell assets at reduced prices, impacting investor returns negatively. These concerns underscore the need for a thorough understanding of the potential risks associated with these investment vehicles.

Examples of Liquid Alt Strategies and Sub-Categories

Morningstar has identified various liquid alternative strategy categories, with popular ones including long-short equity, nontraditional bond, market neutral, managed futures, and multialternative. Each strategy serves different investment objectives and risk profiles, offering investors a diverse range of options to suit their preferences and goals.

• Long-Short Equity: Focuses on equity securities and derivatives, combining long and short positions based on the fund’s macro outlook.
• Nontraditional Bond: Takes unconventional approaches to bond investing, striving for uncorrelated returns with the bond market.
• Market Neutral: Aims to reduce systematic risks by balancing short and long positions across sectors.
• Managed Futures: Primarily invests through derivatives, utilizing various strategies like momentum or mean-reversion.
• Multialternative: Combines different alternative strategies for diversified exposure.

Other categories like bear-market, multi-currency, volatility, and trading-leveraged commodities offer further avenues for investors to explore. It’s crucial for investors to analyze the different structures and strategies within the liquid alternatives space to make informed investment choices aligned with their financial objectives.