Do Liquid Alts Justify Their Costs?
March 17, 2015
by Robert J. Martorana, CFA
Liquid alts are complex and expensive, so it is natural for advisors to ask if they worth the time and trouble. In this article, I answer this question with clear definitions, comprehensive data and a robust framework for portfolio construction. I evaluate returns with special emphasis on 2014, when managed futures (notably the AQR Managed Futures Strategy Fund – AQMIX) soared and the largest global macro fund, MainStay Marketfield (MFLDX), stumbled.
I use Lipper’s classifications for liquid alternatives. Lipper defines liquid alts as strategies with low correlations to traditional asset classes. Lipper excludes MLPs, REITs and TIPS, as well as direct ownership of commodities and precious metals. Lipper does include leveraged and inverse ETFs as liquid alts in dedicated short bias funds, even though one could argue that these are not truly “alternative.”
I assume that the key role of liquid alts is long-term diversification via non-correlation to traditional asset classes, specifically equities and fixed income. Liquid alts can diversify a portfolio of traditional assets classes that are readily available via ETFs and passive funds. The data shows that fee-based advisors are especially interested in using alts to provide diversification. This partly reflects the challenges of Retiring in a Low-Return Environment, which were described in a recent article by David Blanchett, Michael Finke and Wade Pfau.
As Blanchett and his co-authors aptly noted, low interest rates and low prospective investment returns force advisors to challenge the conventional assumptions of retirement planning like safe withdrawal rates (SWR). I would go a step further and say that lifetime income is among the greatest unsolved problems in finance, at least from the perspective of retirees. Lifetime income solutions must address longevity risk, volatility drag and sequence-of-returns risk, and the income solutions must do this in a low-return environment.
There are a variety of investment approaches that address the challenge, ranging from deferred-income annuities to dynamic withdrawal strategies. The thought leaders on Advisor Perspectives and APViewpoint have written extensively about these approaches, and I defer to their expertise. I will add to the discussion by taking a look at liquid alts.
Very few liquid alts live up to the hope and hype that is rampant in the mutual fund industry. After reviewing hundreds of funds for Alts Democratized, it became quite clear that most promise alpha and non-correlation, but most deliver beta and correlation. The correlation of these funds to traditional asset classes is particularly unfortunate because volatility management is extremely challenging in the current market environment.
Here are my assumptions for constructing a portfolio using liquid alts:
- Low-cost core: The core exposures to stocks and bonds could be ETFs, passive funds or some other approach (Dimensional Fund Advisors, managed accounts, individual stocks and bonds, etc.) depending on the advisor and the size of the account. My key assumption is that liquid alts complement what the advisor is doing in the core of the portfolio; you cannot blindly add alts to the mix.
- Opportunistic satellite: Liquid alts would be in a satellite consisting of 0% to 20% of the portfolio, depending on the client’s goals, the advisor’s value proposition and the firm’s due diligence. If the proper framework is not in place, liquid alts do more harm than good.
- Cost-effective at the portfolio level: Liquid alts generally have higher fees than other mutual funds Unfortunately, the expenses for most liquid alts are not justified because they fail to deliver either uncorrelated returns or significant alpha versus a benchmark. But there are a few asset sub-classes that are attractive as portfolio diversifiers. Managed futures is the best example since it has delivered uncorrelated returns that are attractive in a low-return environment. Managed futures funds should be evaluated by their ability to mitigate volatility. Additional research would be necessary to quantify the degree of volatility reduction, the net costs to the client, and a comparison to other asset classes, including cash. But advisors should not look at the costs of an investment product in isolation of the benefits it provides, especially if those benefits cannot be realized in an ETF or passive fund. This is why I say advisors should focus on expenses at the portfolio level rather than the product level.
- Diversifying equity risk: Stocks are part of the core holdings in retirement portfolios. To counterbalance equity risk, fixed income has historically been the go-to asset class. But given current levels of credit and interest-rate risk, bonds could prove to be an expensive form of insurance. So the need for volatility management creates high demand for uncorrelated assets.
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