• Alternative Investments

Liquid Alts – Is the Liquidity Worth It?

calendar_today January 14, 2019

With volatility back in a significant way, interest in alternative investments continues to rise.  For investors, an easy way to get alternatives exposure is through liquid alternatives.  While liquid alts have some advantages, don’t be seduced by the notion of liquidity.

Liquid Alts have brought a mixed bag of results.  While the structure helps investors avoid many of the challenges of investing in traditional limited partnerships, the end results have often come at a significant disadvantage to investors.  On the positive side, tax reporting is simpler, and investors have better visibility into their portfolios with the enticing ability to sell positions daily.

Unfortunately, these benefits come with a steep price in terms of performance.  The average liquid alternative long short equity mutual fund has barely shown a pulse since the end of the credit crisis.  While there are certain exceptions, forcing fund managers to hold positions that may require a sale at any time, has shrunk the investment universe and led to more closet indexing.  As a result, fund managers are unable to concentrate their portfolios in the small cap space (historically a large alpha segment) to focus on their best ideas as many of these names would be impossible to trade out of quickly due to float limitations.

In addition, we saw what happened in the credit space a few years back when liquidity for certain positions dried up for fixed income focused mutual funds.  The redemption restrictions of traditional hedge funds and private credit funds provide tangible benefits to investors.  As we get deeper into this credit cycle and corporate credit continues to extend, it behooves investors to have their capital with managers that can afford some patience when the broader selloff eventually begins.

Three things that investors should consider when debating between a liquid alts fund vs a hedge fund:

• Lack of true short selling picks.  In the long short equity space, many liquid alts funds simply short ETF positions instead of individual company names
• Limited ability to concentrate in short names, an area that has historically generated the most alpha for managers due to the lack of sell side research.
• Limited ability to hold other less liquid positions such as in distressed debt, another asset class where alts managers have historically generated significant returns

We are also seeing more funds dabble in interval structures to help mitigate some of the above-mentioned challenges of daily liquidity while gaining access to more alternative strategies.  While these structures have delivered as advertised in the up markets, we note that one prominent interval fund just put up a gate in the face of oversubscribed withdrawal requests.  As such, investors are unable to get full liquidity at a time when they most want it.

In conclusion, when investing in alternatives, liquid alts have tangible benefits such as more simplified tax reporting and greater transparency of positions.  While those are important considerations, the investment disadvantages described above from liquid alts vs. limited partnership structures should not be ignored when building an alts portfolio.