Liquid alternatives are broadly defined as strategies that are available in registered funds (mutual funds, exchange-traded funds and UCITs) that seek to provide investors with diversification benefits and downside protection.
Following the financial crisis, liquid alternative funds grew rapidly as more allocators sought to introduce sophisticated portfolio construction methodologies across portfolios. In recent years, however, growth has slowed as many early adopters expressed frustration that performance had failed to match expectations.
In retrospect, these first generation liquid alternatives often failed to deliver the promised diversification benefits, paving the way for a new generation of products.
Filling a traditional allocation “bucket” is easy: a cost-sensitive investor can simply buy an exchange-traded fund with, say, all 500 stocks in the S&P 500 index. But there is no simple way to invest in the hedge fund “bucket” given the indexes consist of hundreds (sometimes thousands) of individual, illiquid hedge funds. Investors need to reduce idiosyncratic fund risk by spreading their bets over dozens of funds. As we will explore below, idiosyncratic risk and return dispersion are much higher among hedge funds than traditional assets.
First generation liquid alternatives products came in two general flavors: multimanager products designed to be “one-stop” solutions for the bucket and single-manager offerings akin to individual hedge funds. There have been three primary issues with these:
1. Structural underperformance of some liquid alts relative to hedge funds
While multimanager funds offered potential diversification akin to a portfolio of hedge funds, they suffered from two issues: poor net-of-fee performance and particularly high fees. Over the past five years multimanager mutual funds averaged 1.9% a year, or slightly more than half the 3.4% delivered by hedge funds of funds. Consequently, the funds underperformed despite a modest advantage on fees.
Another example is managed futures, where you can compare the performance of CTA mutual funds with CTA hedge funds. The Societe Generale CTA mutual fund index has underperformed the hedge fund counterpart by approximately 270 basis points a year since inception of the former in January 2013. Here, most attribute the underperformance to limitations on leverage. Whatever the reason, over the past three years, a persistent drag of 2% to 3% eliminated almost all cumulative performance — difficult to justify, to say the least.
2. Fees that are 'low relative to hedge funds' can still be prohibitively expensive
Hedge fund fees have taken center stage recently. Many first-generation products were designed with the pitch that, “if it's cheaper than hedge funds at 2-and-20, it's a great deal.” Multimanager mutual fund marketing material often highlighted the fact that fees and expenses were “half” those of hedge funds of funds.
But half of 5% is untenably high for fee-sensitive investors. The average expense ratio of the multimanager mutual funds described above is around 2.6% today. For a target-date fund with an expense ratio of 40 basis points, a 10% allocation would increase the expense ratio by roughly half. Given regulatory oversight and competitive pressures, this is almost certainly a deal breaker.
When the average multimanager mutual fund has returned 1.9%, a 2.6% expense ratio means that nearly $6 of every $10 made by the fund were paid away in fees — a worse ratio than for most hedge funds.
3. Dispersion of single manager funds
The final issue is the dispersion of performance among hedge fund strategies. Among equity hedge funds that reported to the HFR database between 2000-2016, the average annual dispersion between the top and bottom decile performers was 40% — and has been as high as 80 percentage points in a single year. This dispersion introduces fund selection risk that is an order of magnitude higher than in most traditional strategies. The same holds true for liquid alts funds.
The first generation of liquid alternatives strategies solved the “access and liquidity” issues. However, there were far fewer options than among hedge funds themselves, and the fund selection team would typically select a single liquid alternative fund.
Selection of a single fund failed to address the dispersion issue in hedge fund strategies. In a performance comparison of 36 equity long/short mutual funds over the past five years, the spread between the top and bottom performer was 154 percentage points.
Generation Two: performance, cost and consistency
Given the issues with first-generation products, Generation Two should satisfy three criteria for allocators:
Performance: Match or outperform a hedge fund index, especially no structural underperformance
Cost: Have a low all-in fee structure that is comparable to traditional funds and attractive to fiduciaries
Consistency: Deliver consistent results akin to those of a highly diversified portfolio of alternative managers
Hedge fund replication seeks to identify the core drivers of performance of hedge fund strategies and invest directly in liquid and transparent instruments (futures, ETFs, etc.) to deliver comparable results. Replication strategies have several features that align with the Generation Two objectives above; namely they:
- seek to match or outperform a diversified pool of hedge funds (outperformance usually comes from targeting pre-fee returns with a much lower fee structure);
- work seamlessly within the constraints of mutual funds, UCITS funds, ETFs or similar vehicles;
- closely match the performance of the target pool of hedge funds (e.g., eliminate underlying manager risk); and
- have an efficient fee structure.
Replication-based strategies have been around for 10 years, and the obvious question is how have they performed relative to actual hedge funds.
In order to show comparable results, we use two bank-sponsored replication products that have been continuously offered over the past decade to avoid any question of backtesting. Since replication products have daily liquidity, we compare the results to both the illiquid HFRI Fund of Funds index (an accurate representation of asset-weighted portfolios) and liquid HFRX Global Investible Hedge Fund index. To make the numbers comparable from a net-of-fee basis, we deducted 0.75% a year from the replication products, although we did not make a comparable adjustment to the HFRXGL. Over the past 10 years, two bank-sponsored replication products outperformed the HFRI Fund of Funds Index by a cumulative 7.7% on average and outperformed the HFRX Global Investable Hedge Fund Index by a cumulative 27.2% on average. Furthermore, the replication products had comparable standard deviation and lower drawdowns during the 2008 crisis. From the perspective of an allocator, stable outperformance with lower drawdowns is highly valuable.
Hedge fund replication remains controversial among institutional investors. However, after 10 years of results, critics of replication have been forced to acknowledge several key conclusions.
First, replication does not systemically underperform hedge funds — in fact, it has a 300-basis-points head start on fees. Second, replication is lower risk than hedge funds: no gating risk, no unexpected drawdowns during a liquidity crisis like 2008 (when the illiquidity premium went negative), and no single stock crowding risk (a big reason replication outperformed leading hedge funds in 2015-16). Third, the sources of “alpha” that are not “replicable” — primarily stock selection and illiquidity — are insufficient to warrant the 2-and-20 fee structure.
Today, as reality has set in on some of the limitations of first-generation products, allocators are looking for more reliable, cost effective, longer-term solutions. Whether through replication or other means, second generation products must focus on outcomes and realistic results, preferably those backed by a decade or more of concrete evidence.
Andrew Beer is managing partner at Beachhead Capital Management, New York.