Institutional investors have been utilizing alternative investments for nearly as long as either of the two have been around, but institutional use of alternatives has rapidly increased over the past decade, due in large part to the two significant market declines seen in the 2000s. In acknowledgement of this trend, Lake Partners has issued a white paper intended for institutional investors titled Understanding and Evaluating Liquid Alternatives: How Institutional Investors can Enhance Diversification with User-Friendly Alternatives.
According to the report, the average university endowment or foundation allocated over half of its assets to alternative investments, on a dollar-weighted average basis, as of the end of 2013. On an equal-weighted basis, 28% of assets were allocated to alternatives, 49% to stocks, 18% to bonds, and 5% to cash. This, of course, is quite a departure from the “60% stock, 40% bond” asset allocation traditionally recommended to retail investors.
Among alternative investments, hedge funds received the largest share of fund assets, followed by private equity. This is consistent with the paper’s assessment that institutions have typically used privately offered investments to access alternatives, but the growth of liquid alternatives is changing that. The number of alternative mutual funds “nearly tripled” between 2008 and the end of 2013, providing institutions with more “user-friendly” options. Alternative assets under management grew by an even larger amount, rising from $30 billion in 2008 to $132 billion by the end of 2013.
Structural Differences Driving Demand
Demand for liquid alternatives was likely stoked by the financial crisis, during which the illiquidity of traditional alternatives caused them to “gate” any outflows to investors seeking fund redemptions. Liquid alternatives offer investors exposure to alternative strategies regulated by the Investment Act of 1940, ensuring transparency, liquidity, and the publication of a daily net-asset value, which all work to mitigate risk. The chart below highlights some of the key structural differences between alternative mutual funds and hedge funds:
What’s more, the evolving manner in which liquid alts are used has made them “mainstream,” according to Lake Partners. Instead of simply pursuing excess returns via the stock selection of a skilled active manager, liquid alts are now viewed as effective diversifiers, lowering risk by reducing investment correlation and the risk of substantial account drawdowns.
Lake Partners concludes its 9-page report with a list of practical considerations for institutional use of liquid alternative funds. Investing in alternatives requires special due diligence and analysis, but liquid alternatives may be comparatively “user-friendly” for institutions without much experience investing in traditional alternatives.
Evaluating Liquid Alternative Funds
When evaluating liquid alternatives, Lake Partners recommends a manager-centric approach. First, institutions should identify their objectives, constraints, and risk-reward parameters; then they should develop a strategic overview and identify potential alternative funds. From there, a thorough review of each fund manager’s history, experience, and investment approach should be undertaken to ensure their profiles are in line with the institution’s investment objectives and risk tolerance. Specifically, Laker Partners recommends consideration of:
- The manager’s investment style and risk management
- The manager’s decision-making process, including the degree to which it is flexible, and how much discipline the manager has demonstrated
- The manager’s integrity, reputation, and motivation
- The manager’s ability to articulate a clear investment approach
Ultimately, Lake Partners finds the “democratization of alternative investment strategies” to be a good thing for institutional investors, as liquid alts “bring potential diversification benefits to a broader range of investors,” and allow institutions to implement their alternative investment allocations across “the liquidity spectrum.” With enhanced transparency and liquidity, liquid alts are a potentially good fit for institutions as well as retail investors.