Senior Manager | CAPTRUST Consulting Research Group
Alternative investments have traditionally been reserved only for the most sophisticated institutional and high-net-worth individual investors. Because of product innovation, that trend is changing. The development of alternative mutual funds and exchange traded funds has brought a once seemingly exclusive investment tool to more investors through “liquid alternatives,” a term we use to describe alternative investment strategies available in daily priced investment vehicles like mutual funds.
Liquid alternatives have been a fast-growing and quickly evolving product set since the financial crisis. While the crisis wreaked havoc on so many areas in the investment industry, it provided a catalyst for this segment’s further growth. It also immediately focused investors on liquidity concerns, especially within their alternative allocations. While many investors have continued to believe in these strategies’ investment merits, they have become increasingly leery of their illiquidity. As a result, over the last four years investors have poured assets into liquid alternatives. Last year alone, liquid alternatives soaked up $23 billion in investor inflows. To put that in perspective, investors withdrew $85 billion out of U.S. equity mutual funds during the same time. Liquid alternatives have grown from an asset base of under $40 billion in 2006 to over $120 billion at the end of 2011. The number of available products has also exploded. In 2007, there were only 11 new liquid alternative mutual funds launched. In 2010 and 2011, the industry launched a total of 54 and 79 products, respectively.1
As the origination and growth of liquid alternatives signals a potentially exciting new era for investors, it brings with it a unique set of challenges and risks. On one hand, liquid alternatives eliminate some of the most obvious risks associated with private alternative investments, including liquidity risk and transparency issues. However, underneath these simplified vehicles are still complex investment strategies. Additionally, because of the need for liquidity, they may provide investors with only a diluted version of an investment they could access in private form. The fact that most of these products are still in their infancy with little to no public track record to analyze makes life tougher.
During the first half of the year, our due diligence team conducted an exhaustive review of the entire liquid alternative universe in order to create a guide to this complex product set. The goal of this project was to strip away any predefined categories and analyze these investments strictly from the bottom up. While Morningstar has developed their own categorization for these investments, which includes seven different categories, we started by identifying the entire opportunity set regardless of assigned category. This was crucial in certain categories. While some of Morningstar’s categories are relatively straightforward and useful, others are more nebulous, nuanced, and complicated. For example, Morningstar’s “multialternative” category captures two different investment strategies that we would consider distinct: fund of hedge funds and multi-strategy. In the first, a manager allocates to a collection of sub-advisors, who often specialize in a particular strategy, region, or industry. With the second, the multi-strategy manager invests directly in complex markets across a number of different hedge fund strategies. While overall portfolio positioning and characteristics could be similar between a fund of hedge funds manager and a multi-strategy manager, the investment strategies themselves are completely different and distinct. We applied our expertise to this analysis, brought from the same methods and comprehensive tools gained from providing coverage and analysis of private alternative products.
Today, the current liquid alternative universe consists of around 230 products. For our review, we identified 110 of those that initially met our criteria. After due diligence began, the list quickly shrank to 57. Of those 57, a small subset were identified as true investment opportunities that we would consider for Client portfolios. The prevailing products represent a broad range of alternative investment categories. While many are strategic in nature, a few are more tactical and should be used only to capture a specific opportunity. While we have completed an initial assessment and have identified a number of potential Client solutions, this space continues to grow and evolve. As it does, we will continue to ensure that Client portfolios, where appropriate, maintain exposure to the most skilled managers in the liquid alternatives domain.
1 Morningstar and Barron’s 2011 Alternative Investment Survey of U.S. Institutions and Financial Advisors, May 2012.