Markets in a Minute: Liquid Alternatives

Until recently, many investors had given up on all but two asset classes: stocks and bonds. Looking at recent returns, it’s not hard to see why. 

Between early 2009 and last year, the broad U.S. equity and bond markets gained nearly 19% and 4%, respectively, on an annualized basis. This was certainly cause for celebration. And yet, the impressive performance of stocks and bonds had an unintended consequence: Today, a vast majority of portfolios are invested solely in these two asset classes. 

While that’s understandable, we think it’s important to consider additional investment types when building your portfolios for the next decade. Many investors have begun to add commodities and real estate equities to their portfolios, given their recent performance and perceived inflation-hedging benefits. But it may also be a good time to consider a thoughtful allocation to the presently unloved liquid alternatives universe. 

Before we explore why, let’s take a closer look at the often-misunderstood world of liquid alternatives, or liquid alts. 

What exactly are liquid alts, and how did they originate? 

• Liquid alts are publicly offered, SEC-registered funds, typically mutual funds. They have a lot in common with hedge funds but some important differences too. 

• Like hedge funds, liquid alts generally seek to provide investors with diversification from equity risk and thus downside protection. They tend to own non-traditional investments, such as global real estate, start-up companies or commodities, like gold or oil. Often, these funds use complex investment and trading strategies — such as selling stocks short, using derivatives, or following “absolute return” or “market neutral” strategies that seek positive returns when stock markets decline.

• Most liquid alt funds were created after the bear market of 2000-2003 that followed the bursting of the internet bubble in response to investor demand for hedge-fund-like strategies in a liquid format. 

• Unlike hedge funds, liquid alts don’t require investors to lock up their money for certain periods of time. Shares of these funds can generally be bought and sold daily, just like traditional mutual funds, and that’s what makes them “liquid.” Another key difference: Any investor may buy shares of liquid alt funds, but hedge fund shares are only available to high net-worth investors that meet certain criteria. 

Despite the initial excitement surrounding liquid alts, the honeymoon didn’t last long. Over time, many investors have grown disenchanted with the funds — largely because of their underperformance relative to stocks and the traditional 60/40 portfolio. 

Rather than comparing the performance of liquid alts to stocks, we think it makes more sense to view them through a different lens. Stick with us here. 

If the purpose of liquid alts is to diversify the equity risk of portfolios, bonds, which play the same role, seem to be a better basis for comparison. From this perspective, liquid alts have generally performed decently over the last decade. On average, the seven liquid alt categories in Morningstar Inc.’s database have provided comparable returns to the broad U.S. bond market over the last 10 years.

The Long View: How Liquid Alts Have Performed Relative to U.S. Bonds 

^{Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index. Source: Morningstar. This chart shows trailing performance of current liquid alternatives category averages relative to the Intermediate Core Bond category average.} 

During the first quarter of 2022, each of Morningstar’s liquid-alt category averages outperformed both stocks and bonds. It was also an unusual period in that stocks and bonds have rarely declined in unison by this magnitude. 

The standout performer was the Systematic Trend category, which has been a notoriously difficult fund type to own over time, given its higher volatility. This type of strategy, commonly referred to as trend-following, generated attractive returns from 2000 through the 2008 financial crisis but has produced mostly disappointing results in the post-crisis period. The category is unique, however, in its low long-term correlations to both stocks and bonds, as well as its propensity to invest in the most-liquid markets across currencies, commodities, stocks and bonds.

Systematic Trend Shines in Early 2022 

 
_{Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index. Source: Morningstar. Data from 1/1/22 – 3/31/22. This chart shows the YTD performance of the current Morningstar Liquid Alternatives category averages relative to the SPDR S&P 500 ETF and iShares US Aggregate Bond ETF.}

Before You Invest 

Navigating the world of liquid alts is a lot more complicated than picking traditional stock and bond funds. That’s why careful due diligence is critical. When adding liquid alts to a portfolio, keep the following principles in mind:

• Seek funds that provide actual diversification benefits to your core stock and bond positions (low correlation).Be aware of volatility: More-volatile funds will have a bigger impact on both the way up and down.

• Don’t put all your eggs in one basket: Always implement with strategies in more than one category. Even multi-strategy funds tend to have positive correlations to equities.

• Invest in alts strategically: These strategies can be extremely dynamic, with constant changes in their underlying holdings. This makes it extremely difficult to time when they will perform best.

• Be biased: Choose larger funds with longer histories within each category. The field of liquid alts has narrowed significantly over time. Our research finds that only about 180 of the more than 500 funds created since 2005 still exist. Since fund companies rarely eliminate funds with good performance, the above-mentioned category averages likely overstate the experience that past investors may have achieved.

• Be aware that fund fees may be relatively high. Owing to the generally complex nature of these strategies, low-cost index funds have not yet proliferated in the liquid alts universe, as they have in the traditional stock and bond fund markets. 

So, why even consider liquid alts given the complexity and the difficulty in selecting funds that are likely to survive? 

First, while stocks and bonds should always form the core of a well-diversified portfolio, their future returns are likely to be lower than what has been achieved over the last 12-plus years. Second, while bonds have exhibited low correlation to stocks over the same period, future correlations may not be as low as they have been. 

For these reasons, we believe a thoughtful allocation to liquid alts offers the potential to improve a portfolio’s risk-adjusted returns. 

If you have questions about your asset-allocation strategy, don’t hesitate to reach out to your financial advisor. 

^{The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Private Wealth Services, LLC, Kestra Investment Services, LLC, Kestra Investment Management, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by any entity for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Private Wealth Services, LLC, Kestra Investment Services, LLC, Kestra Investment Management, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC does not offer tax or legal advice.}