Checking in on Liquid Alternatives by Attain Capital

With the VIX rising just under 50% over the past month, a high schooler lying about making $72  Million day trading, and Crude Oil dropping like a rock, a lot of folks might be spending their holiday downtime Googling Alternative Investments. And when they do, they are likely to run into the term “Liquid Alternatives” or more colloquially:  “Liquid Alts.”

What exactly are Liquid Alternatives? Essentially, they are Hedge Fund type strategies (so called Alternative Investments… the Alts part) that are packaged in a mutual fund or ETF which offer daily liquidity and the ability to click and purchase (the Liquid part). Dig a little further and you’ll run into the term ’40 Act Fund’. What the heck is that?

via Citi:

“A ’40 Act fund is a pooled investment vehicle offered by a registered investment company as defined in  the 1940 Investment Companies Act (commonly referred to in the United States as the ’40 Act or, in some instances, the Investment Company Act (ICA). Such pooled investment vehicles fall into two broad categorizations: open-end and closed-end. When combined with the Securities Act of 1933 (the ’33 Act) and the Securities Exchange Act of 1934, the ’40 Act defines the way in which these types of pooled investment vehicles can be packaged and sold to retail and institutional investors in the public markets, and places their governance under the responsibilities of the Securities & Exchange Commission (SEC).”

So, you have alternative investment strategies designed for sophisticated investors re-packaged into products that are ok for non-sophisticated investors. It’s like ordering a salmon burger at McDonalds… It comes in familiar packaging (with fries), but is anything but the normal fare you’re used to in that packaging.  Just how popular are the Liquid Alt ‘Salmon Burgers’, according to a recent CNBC article, Liquid Alts were standing at right around $280 Billion back in September.

A popular product bringin tons of assets… what could go wrong? Well, if you’re a frequent reader of our blog, you’ll know we’re not the biggest fans of Liquid Alternatives. This isn’t the most popular opinion to have, which is why it’s always nice to see someone else in the business share some of the same thoughts. We’re talking about Concept Capital’s Jack Seibald’s interview on Hedgeweek.

Seibald starts off saying that the popularity of these liquid alternatives is a bit alarming because they are assumed to be ‘safe’.

 “…We have seen such a significant proliferation of liquid alternatives that it should raise a lot of red flags, particularly because, as SEC registered vehicles, they create an aura of safety. Investors are lulled into believing these funds are okay. After all, they trade like a mutual fund. My concern is that there are a whole host of investors for whom the underlying strategies make absolutely no sense. There’s a real potential mismatch of the risk and potential reward of the fund, and investors’ expectations for such.”

Then calls the premise behind the whole thing (launching a liquid version of a non liquid strategy) farcical (love that word):

HW: The argument made is that a hedge fund manager launching a ’40 Act fund does so on the proviso that it is a completely different fund that cannot be expected to mirror the flagship hedge fund’s performance.

JS: I accept that, but that’s what makes it farcical in my opinion. If you’re going to run a different strategy then you shouldn’t dress it up as some new fangled way to get exposure to hedge funds. If the manager is running a necessarily different version of the hedge fund strategy, that’s fine, but is that liquid alternative really reflective of the hedge fund manager or are they having to make significant compromises in the manner in which they invest the portfolio?”

How about watered down performance…he’s got that covered:

“What appears to have gone out the window is the original premise of hedge funds, that is to make outsized returns. If a manager receives a USD300mn allocation from an institution, they won’t want to lose that investor so they may be inclined to take less risk and to accepting of generating potentially lower returns.

Offering Memorandums and pitch books for managers used to say that their aims were to generate outsized returns in favourable market conditions and preserve capital in less favourable market conditions. It’s been a long time since I last saw one like that. Now, for the most part, it’s a much more generic pitch about managing risk and capital preservation.”

As we’ve stated before a lot of these funds launched after the last crisis period, and we’ll be interested to see how many of them perform in the manner they describe their strategy. While Seibald doesn’t outright say the exact statement, he makes a pretty forward claim, that those getting into 40 act funds because it’s “trending” will fade away.

HW: Finally, how do you see this ’40 Act fund trend developing?

JS: It’s not unreasonable to assume that the liquid alternative evolution is not going to be smooth for the reasons discussed above. The concern I have for the industry is that too many managers get distracted by the idea of potentially raising more assets more quickly and look to liquid alternatives to do that. For managers  with strategies and track records of outsized returns, and remain focused on their hedge funds, I suspect the future will be fine as they will continue to attract capital from investors seeking such performance. For some portion of managers who explore the ’40 Act route, things will work out as well. I fear that for a significant number of managers who try it, it won’t.”

Finally, for any managers out there considering getting involved in the 40 Act world, bring your checkbook…

HW: We’ve not even touched upon the hard and soft costs of launching one of these vehicles. This is a significant burden for anyone wishing to launch a standalone ’40 Act fund.

JS: The hard costs relate to establishing the ’40 Act fund, operating it on a day-to-day basis and having to pay all the service providers and regulatory fees, not to mention paying a fund sponsor to go out there and sell the fund. If you’re collecting 1.5 per cent in management fees, you’re not keeping much of that unless the assets grow to hundreds of millions or billions.

We hear from managers and service providers that the break-even on a self-managed ’40 Act fund could be anywhere between USD30-100mn, though I suspect that the latter is the more realistic level. So, until you raise that 100mn you are out of pocket a good deal of money.”

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Checking in on Liquid Alternatives