Liquid Alternatives

Liquid alternatives or “liquid alts” are funds that are not constrained by traditional asset allocation rules. A traditional fund takes long-only positions in a basket of common stocks or bonds. Liquid alts, on the other hand, may take long or short positions in stocks or bonds, options, derivatives, commodities, and other asset types. They can follow different trading strategies such as event-driven, quantitative, technical/momentum-driven, or low-volatility. Thus, they provide smaller investors with a way to gain exposure to these strategies, which were previously only available to institutions.

Before I go into details on liquid alts, I should mention perhaps their largest drawback for smaller investors: they tend to have high fees and transaction costs. Over 100 liquid alt funds were launched in 2014, and nearly all of them have expense ratios between 1 and 2 percent. Only a few are available as ETFs through retail brokerage accounts; the majority have to be accessed through an investment advisor who may take additional fees. Given these high fees, I question whether liquid alternative funds belong in any retail investor’s account.

So why would anyone buy these things? Well, I can summarize the narrative that’s pitched by the sponsors of liquid alternative funds. It’s basically as a hedge against the risk of stocks or bonds. A lot of investors got burned by stocks in the financial crises. The traditional way to hedge stock market risk was through bonds, but many people believe bonds are currently at the end of a long 30-year bull run. Interest rates will eventually rise, causing bond prices to fall. This is at the same time that stocks have performed extremely well for the past five years and may be overvalued. Thus, there is a risk that stock and bond funds, which have traditionally had a low correlation to each other, will move in the same direction – down.

Liquid alternative funds try to hedge against this risk. They have general mandates but are relatively unconstrained in their trading strategies. For example, look at First Trust Exchange Traded Fund VI (FTLB). Its mandate is

“Invests in dividend paying stocks and sells covered call options on the S&P 500 Index to generate additional income, plus it purchases index based put options to hedge the portfolio from downside risk.”

Basically this means that the fund picks large cap stocks from the S&P 500 and benefits when they go up. It also buys put options on the S&P 500. A put option is the right to sell a security at a specified price. So if the fund buys a put option on the S&P with an exercise price of 2000 and the S&P declines to 1950, the fund has a right to sell it at 2000 and profit off the difference.

FTLB has an expense ratio of 0.85%, which is relatively low for a liquid alt fund (but relatively high for an ETF in general – most ETFs have an expense ratio below 0.40%). It looks like the fund has not been successful in raising much capital; it current has only $3.05M under management and has very low trading volume.

Another common strategy for a liquid alternative fund is the “unconstrained bond fund”. This means the fund can take long and short positions in bonds across a variety of markets, and use hedging and derivative strategies as well. Generally, the goal of an unconstrained bond fund is capital appreciation regardless of the direction of interest rates. In the current environment, with rates expected to rise, this strategy is appealing for investors seeking protection for the fixed income portion of their portfolio.

There are now hundreds of liquid alternative funds with over $250B under management. One thing to keep in mind, which I think is very important, is that liquid alt funds as a whole have never experienced a bear market. The industry as a whole has arisen over the past five years, in which asset prices have been continually climbing. Of course, the marketers of the funds promote the idea that they will perform well and hedge risks regardless of the macro environment. However, this idea hasn’t really been tested yet.