Liquid alternatives are “flowing into the mainstream” according to a new whitepaper by Jack Rivkin, chief investment officer of Altegris Advisors; and co-author Lara Magnusen, an Altegris director. The paper cites a Goldman Sachs estimate that the rapidly growing liquid alts market is in the midst of a 5-10 year growth period that could result with as much as $2 trillion in assets under management within the next half-decade or less.
Rivkin and Magnusen, like many researchers, trace the origins of the liquid alts boom back to the financial crisis of 2008, which led to a liquidity crunch – especially among alternative assets. Now, with the stock market at all-time highs and the thirty-year bond bull market set to reverse when the Federal Reserve finally begins raising interest rates next year, investors are looking for a way to diversify their holdings while maintaining high liquidity, and that’s what liquid alts have been designed to do.
What Are Liquid Alts?
The term “alternative investments” describes investments that are intended to have low correlation to the broad equity and fixed-income markets – essentially, this definition of “alternative” includes any investment other than a stock or a bond. Stocks and bonds have traditionally been the most popular, and thus the most liquid investments, and the Investment Company Act of 1940 (“the ’40 Act”) mandates that, for the most part, retail investors can invest only in regulated portfolios of highly liquid stocks and bonds – i.e., mutual funds. Meanwhile, “accredited investors” have always been allowed to pursue low-correlation returns through private hedge funds available only to the wealthy.
For this reason, mutual funds and alternative investments “existed in different realms,” according to Rivkin and Magnusen, and thus many liquid alts managers lack the necessary experience. On the one hand, hedge fund managers are untested at operating under ’40 Act rules and regulations; and on the other hand, mutual fund managers are unproven at implementing complex alternative strategies. Luckily, firms like Altegris – whose name is an amalgam of “alternatives” and “integrity” – have pioneered liquid alts products, and the company’s managers provide investors with access to “real hedge fund talent” with the experience and knowhow for dealing with disclosure requirements and other ’40 Act particulars.
Why Invest in Liquid Alts?
In addition to gaining exposure to alternative investments in a liquid format, management talent is another reason to consider investing in liquid alts. Furthermore, in the case of retail investors, most illiquid alternative investments are prohibited – these remain available only to wealthy “accredited investors,” which are defined as individuals with investible assets worth greater than $1 million, or annual income of at least $200,000 in each of the past two years. As Rivkin and Magnusen note, liquid alts “give investors access to managers with demonstrated investment skill throughout various markets and with strategies previously only available to the wealthiest investors.” However, not all fund managers are worth the higher fees that liquid alts typically charge, which is why potential investors should perform ample due diligence.
Decorrelation is another major advantage of liquid alts. Most stocks and bonds exhibit a high degree of asset-class correlation, meaning that most stocks tend to go up during broad bull markets and down during broad bear markets, and the same is true of bonds. Thus, it’s very difficult to produce gains, even with a diversified portfolio, if your investments are highly correlated to the broad stock market (or bond market) during a stock (or bond) market downturn. Alternative investment strategies have far less correlation, as discussed below.
Strategies, Returns, and Correlation
In general, the replication of hedge fund strategies within a ’40 Act product is the goal of liquid alts. However, as Rivkin and Magnusen explain, not all hedge fund strategies are able to be implemented under the ’40 Act, due to liquidity requirements and leverage limitations. Furthermore, some active strategies would be susceptible to “front running” if their managers were required to disclose their holdings on a daily basis, as the ’40 Act demands. Rivkin and Magnusen list the five following alternative strategies as the most suitable for liquid alts:
- Long/short equity
- Long/short fixed-income
- Managed futures
- Global macro
- Long/short real estate
Low correlation to the broad stock and bond markets – as well as to each other – is one thing that makes these strategies attractive. In the table below, Rivkin and Magnusen detail the annual returns of the first four strategies cited above, then U.S. stocks, U.S. bonds, and finally real estate. The right side of the table displays the correlation the different strategies have with each other:
Rivkin and Magnusen recommend implementing at least three alternative strategies within the context of a “traditional” stock and bond portfolio, so that the total makeup might look something like this:
- 38% U.S. stocks
- 27% U.S. bonds
- 18% Long/short equity
- 10% Long/short fixed-income
- 7% Global Macro
Rivkin and Magnusen looked at the returns such a portfolio would have generated between January 1990 and June 2014, compared to the returns of a “traditional portfolio” consisting of 60% stocks and 40% bonds, and found that the portfolio containing liquid alts would have produced 10% annualized returns, compared to the traditional portfolio’s 8.8%. The alternative portfolio also boasted a higher Sharpe ratio, indicating superior risk-adjusted returns, as detailed by the graphic below:
Rivkin and Magnusen conclude their report by touting the development of liquid alts as giving retail investors access to the best hedge fund talent within investment products that have high liquidity. Nevertheless, they say “finding the best liquid alternative investments requires a trusted partner.” Investors should ask tough questions, pay close attention, and invest wisely in liquid alts, according to Rivkin and Magnusen.
For more information, download a pdf copy of the report.