What on Earth is a “Liquid Alternative”?

| July 5, 2015 | 0 Comments

Scarcely a day goes by that I don’t receive a call or at least two emails from somebody trying to sell me a “Liquid Alternative” mutual fund. Thankfully, only one of my clients has come to me saying “I’ve got to have some of these.” So what are these things and why might you want to own them?

Sometimes called “hedge funds for the masses,” a liquid alternative fund is basically a mutual fund that uses a hedge fund-like strategy to select its investments. These might include strategies like:
• Market neutral or long-short (buying some stocks while selling short or betting against others at the same time);
• Managed futures strategies, in which the fund manager bets on the future prices of commodities;
• Unconstrained bond funds, where managers can buy any kind of bond of almost any maturity, or even short (bet against) bonds.

The basic goal is to diversify your portfolio. In a market where both stocks and bonds seem unlikely to perform well in the future, then other types of investments or strategies can be appealing.

These funds can have exotic sounding names like “Event Driven Arbitrage” or “Smart Beta” and often come with a compelling sales pitch. But there are some important factors to remember when considering these kinds of strategies.

These things are expensive. According to Morningstar, the average Multialternative mutual fund carries a cost of 2.03 percent per year. With an average 10 year return (through 5/31/2015) of 3.7 percent, you’re paying a lot for that diversification, and there are huge differences from one fund to the next. When you consider the S&P 500 Index of large company stocks earned 8.1 percent per year over the same period, and the Barclay’s US Aggregate Bond Index (representing the total bond market) averaged 4.6 percent, a plain old 60/40 stock bond mix looks pretty good.

Most of these funds are new. Which brings up my second point: There are only 22 funds in that 10 year history, compared to 506 with a three month track record. The vast majority of these funds are brand new and haven’t really been tested through thick and thin.

The strategies are opaque. A lot of the strategies will sound attractive, but at the end of the day, many of these funds end up acting like the stocks or bonds they’re meant to be avoiding, but with much higher fees.

The tax treatment can be different, too. One thing that you have to be careful about with alternative strategies is that they often involve a lot of options or futures contracts. Or frequent trading. This isn’t inherently bad, but these have the potential to create large tax bills that don’t show up in the fund’s performance numbers.

Hedge fund strategies may not work in a mutual fund. Hedge funds have been around for a long time. They have been used by the wealthiest investors to make long-term investments that might be illiquid (hard to get out of quickly) or very complicated. They often involve million dollar minimums, can use massive amounts of leverage and often lock up investments for several years. Mutual funds are much more limited in how much leverage they can use or what they can buy, so these strategies won’t translate smoothly.

Perhaps the most important issue is behavioral. Investors want diversification when things are falling apart, but when the stock market is going straight up, watching a fund tick away with a steady four percent return can get really painful.

If you can find a low cost liquid alternative that truly diversifies the risks in your portfolio, and you can maintain a disciplined allocation to it for the long-term, then some of these things might be worth looking into. A Certified Financial Planner ® practitioner can help you decide if these are right for you.

Personally, I haven’t seen many that interest me.

This column is prepared by Rick Brooks, CFA, CFP®. Brooks is Director and Chief Investment Officer with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at brooks@bfadvisors.com. Brooks and his family live in Mission Hills.

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