Are liquid alternatives the next wave in asset allocation? Matthew Glaser, Managing Director and Portfolio Manager/Analyst at Lazard Asset Management, thinks so. In a recently published Lazard Insights white paper, Mr. Glaser highlights the advantages of liquid alts – long/short equity funds in particular – and asserts that these investments will become increasingly attractive to the growing retirement-age population. Indeed, baby boomers may be responsible for much of the liquid alts “boom” thus far.
Advantages of Liquid Alts
Alternative investments include everything outside of stocks, bonds, and cash. This broad category of investment choices not only includes hedge funds, private equity, real estate, and commodities, but also “exotic assets” like art and collectible wine. But while these alternatives may have the advantage of having low correlation to traditional assets, they each suffer from varying degrees of illiquidity.
As evident by their name, liquid alternatives – by which Mr. Glaser means ’40 Act mutual funds pursuing hedge-fund strategies – are liquid, which is their primary advantage over other illiquid alts. While many of the illiquid (or less liquid) alternative products are accessible only by high-net worth individuals and institutional investors, liquid alternatives are open to all investors.
Alternative mutual funds have daily liquidity and all the transparency and regulatory oversight of traditional mutual funds. They also typically have lower fees, lower initial minimums, and simpler tax reporting than hedge funds. At the same time, liquid alts provide exposure to hedge-fund strategies, such as long/short equity, which have low correlation to traditional assets. Thus, allocating to liquid alternatives alongside traditional assets can potentially dampen the volatility and enhance the risk-adjusted returns of the portfolio.
One criticism of liquid alternatives is that they’re “hedge-fund light” and unlikely to perform as well as “real” hedge funds. Mr. Glaser acknowledges that this may be true of some strategies, which can’t work as well (or at all) under the confines of the mutual fund structure. But this isn’t true of the original and still most popular hedge-fund strategy: long/short equity.
Long/short equity portfolios consist of “long” (owned) and “short” (sold-short) positions. Since the value of a short position increases as the value of the underlying asset decreases (and vice-versa), long/short equity portfolios have low correlation to the broad stock market, since the short portion of the long/short portfolio will tend to have an inverse correlation. Long/short strategies also allow investment managers to express negative views on a stock by doing more than just not owning it – thus doubling opportunities for alpha.
Since long/short equity strategies have low correlation to the broad stock market, they can provide diversification benefits when added to an existing portfolio of traditional, long-only assets. The short aspect of long/short portfolios also provides natural downside protection. As shown in the image below, the HFRI Equity Hedge Index of long/short equity hedge funds has outperformed the S&P 500 in down markets:
Growth and Prospects
Liquid alternatives are already growing rapidly. Overall, liquid alternative assets under management (“AUM”) increased 160% in the five years ending September 30, 2015:
According to Mr. Glaser, 10,000 baby boomers in the U.S. turn 65 every day – and this will continue for the next 14 years. Liquid alternatives have the following features that are attractive to retired investors:
- Lower volatility
- Capital preservation (downside protection)
For individuals of retirement age, “an allocation to non-traditional investments in transparent vehicles represents a sensible solution,” according to Mr. Glaser. Thus, demographic trends bode well for the future of the liquid alternatives industry.
For more information, download a copy of the white paper.
Past performance does not necessarily predict future results.
Jason Seagraves contributed to this article.