June 29, 2021

Will Allocators Ever Embrace Liquid Alts?

Institutional investors mostly want to direct their non-market-correlated strategies themselves, but acceptance of these retail-oriented alternatives is inching up.

Reported by Larry Light

Art by Kyle Smart

Alternative investments are in vogue, although the problem with them is that they often aren’t very liquid. If you need to cash them in to meet some urgent need, tough luck. Hence the rise of liquid alts—ranging from real estate to commodities, private credit to hedge fund-like strategies.

These assets are contained mainly in exchange-traded funds (ETFs), securities that by definition are tradeable, and, to a lesser extent, mutual funds, which can be redeemed with little fuss.

Liquid alts have yet to gain much traction with institutional investors, though, and remain mostly a retail product. “I’m not a fan,” said Jonathan Glidden, managing director of pensions at Delta Air Lines. Sporting expert staffs and a bevy of outside managers, allocators like him are more than capable of doing alt investing themselves. They possess the knowhow, for example, to mount a canny hedging strategy, and don’t need to depend on an ETF, a vehicle whose managers they don’t control.

A further weak point is the innate vulnerability of the tradeable wrappers that liquid alts inhabit. ETFs are subject to the whims of the market, and can be very volatile, regardless of their underlying assets. A Federal Reserve announcement, for instance, can shake up the stock market, causing timberland ETFs to gyrate wildly. Meanwhile, the value of the underlying forests is unaffected.

In addition, redemptions can torpedo ETFs and mutual funds. Let’s say some event stampedes investors to cash out of their funds. This “could have a negative performance impact on the remaining shareholders in the ETF or mutual fund,” warned Sean Bill, CIO of the Santa Clara Valley Transportation Authority (VTA), outside San Francisco.

Another minus has been that liquid alts have had a performance problem. A lot of these assets mimic various hedge fund strategies, such as long-short, macro, and event-driven (mostly mergers). And only recently have hedge funds been able to beat the S&P 500.

Liquid alts, with some exceptions, are still laggards in the return sweepstakes. They rose 4.2% in 2020, versus 16.2% for the stock index (in price terms), according to by the Wilshire Liquid Alternative Index. And thus far this year, through Friday, liquid alts were up 4.6%, as the S&P 500 advanced 14%.

Nevertheless, the point of alts is that they aren’t closely correlated to stocks and bonds. That’s why liquid alts outpaced—which is to say, in most cases, lost less—than the S&P 500 during the 2020 pandemic market panic, from February 18 to March 23. They returned negative 15% compared to the stock index’s 33.7% loss, by Morningstar’s tabulation.

During the early 2020 market rout, AQR Managed Futures Strategy gained 4%. BlackRock Event Driven Equity, which deals in merger arbitrage and its kin, dropped just 9.4%. The largest liquid alt fund, JPMorgan Hedged Equity, with $18.3 billion, slid 18.8%, slightly more than half of the S&P 500’s plummet. “Merger arb is just not correlated” to stocks, said Cynthia Crandall, senior investment analyst at Envestnet.

The Diversifying Dynamic

Created in the wake of the 2008-09 financial crisis to meet a demand for diversification among retail investors, liquid alts nevertheless languished in recent years as the stock market roared. Lately, though, they are enjoying a surge of investor inflows. And that’s despite their high fees. The liquid alts average is 1.6% annually, while mutual funds in general charge a third of that and ETFs overall are even lower.

Some alts obviously are more liquid than others. Agricultural and energy commodities, for example, have well-oiled trading mechanisms, from spot markets to futures exchanges. Even positions in private equity and hedge funds can be traded. Dozens of secondary shops, such as Landmark Partners, have been providing a market for these asset classes for years.

Yet ETFs in particular are known for their trading speed, which is why investing pros often use them to hedge. A sell or buy can happen with a couple of mouse clicks. What’s more, their wide diversity can help managers balance out risks, maintained Kelly Ye, director of research at IndexIQ.

She divides liquid alts into three groupings. First are “return enhancers,” which corelate to the market but have a shot at beating it. These include, for instance, event-driven funds, which seek to arbitrage any pricing inefficiencies in mergers, spinoffs, Chapter 11 filings, and other corporate changes. Also, long-short equity, where profits can be gleaned when stocks dip. Next are “diversifiers,” such as market neutral funds, which aim to deliver a positive return despite what the market does, via derivatives and shorting stocks. Then come “volatility dampeners,” the least correlated to stocks. They often use commodities.

Certainly, the varying types of liquid alts present an investor with a real smorgasbord of choices.

“A high level and broad sweep runs the risk of overlooking the diversity of liquid alternatives,” said Shawn Park, Calamos’ vice president of product management and analytics. “The risk in generalizations about alts is that they may discourage use. Today’s alts offer unique value, if you’re willing to look.”

Institutional Adoption

Right now, institutional investors who aren’t running their own in-house alts programs get alt exposure through limited partnerships (LPs), separately managed accounts, and the like. But liquid alts have been penetrating the institutional market, said IndexIQ’s Ye.

Indeed, liquid alts represent about 4% of institutional assets, with average allocations ranging from a high of 6% of total assets among public pension funds to a low of 2% among corporate funds and outsourced chief investment officers (OCIOs) in the US, according to a Greenwich Associates study. Smaller plans with less than $1 billion tend to use liquid alts, pointed out Gerald Prior, chief operating officer (COO) of Mount Lucas Management, which oversees assets for institutional clients.

Among institutional funds, the very idea that an alt is liquid is almost an oxymoron. Take our timberland example: Hundreds of wooded acres, whose trees will be felled to make lumber in the years ahead, have little relationship to Fed news that agitates their ETFs’ pricing. “There is a mismatch between daily liquidity and the underlying asset,” said Stuart Katz, CIO of Robertson Stephens Wealth Management.

To Delta’s Glidden, managers who need liquidity can find it in other parts of their portfolio. The point of getting into alts, he said, is “to better harness the power of informational inefficiencies and to allow skilled asset managers to roam freely, i.e. with fewer constraints, to add value.” And that is exactly what liquid alts don’t deliver, he argued, adding, “liquid alts fly in the face of both of the central tenets of alts.”

Many asset allocators have the scale and breadth to manage alt strategies in-house or to contract it out to others, whom the allocators oversee. Paul Colonna, CIO of Lockheed Martin Investment Management, for instance, said his staff manages a $3.5 billion hedge fund strategy, “where we directly select managers across long-short equity, credit, and merger arb.” Plus, his group internally runs a balanced risk investment involving stocks and bonds, yes, and also commodities, an alt class.

While leery about the liquidity mismatch problem, VTA’s Bill does dabble with liquid alts in a small way. He’s invested around $50 million, or 5% of his program’s holdings, in the Principal Diversified Real Assets mutual fund, as an inflation hedge.

This mutual fund contains inflation-indexed bonds, real estate investment trusts (REITs), commodity index-linked notes, fixed-income securities, securities of natural resource companies, and master limited partnerships. Note that all these underlying assets are publicly traded, so some of them can be influenced by the crowd psychology-induced movements of broad markets. Liquid alts also could work for options and commodities, he added, as they often aren’t correlated.

One argument favoring liquid alts, in the Greenwich Associates study, is that these are a good place to park dollars while transferring from one outside manager to another, instead of in a low-paying money market fund. An allocator quoted in the report remarked that “I might use liquid alternative ETFs for transition management because it can take up to two or three years to get all your money invested. A liquid alternative ETF can be a nice placeholder.”

In the investing world, things change all the time. Once, no one wanted to touch junk bonds. Or, for that matter, alternative investments. That’s not the case now for either asset class. Liquid alts may someday join them in polite financial society.