Alternative, "alt" or “liquid alt” funds are publicly offered, SEC-registered funds that use investments or strategies that can differ from what is offered in a typical fund. Compared to more traditional mutual funds and exchange-traded funds (ETFs), liquid alt funds tend to focus on investments that extend beyond equities and bonds or employ more complex or sophisticated strategies. If you’re considering liquid alts, be aware of their unique characteristics and risks, so you can better assess whether (and if so, how) they might fit into your portfolio.
What Are Alternative Funds?
As the name implies, alternative funds seek to accomplish their objectives using alternatives to more traditional, or “plain vanilla,” investments and strategies. Sometimes marketed as hedge funds for the masses, these funds are often referred to as “liquid alts” because you can generally trade in and out of them as you would any mutual fund or ETF, making them more liquid than hedge funds that also offer exposure to alternative assets and strategies. (Note that some hedge fund strategies or other private investments cannot easily be packaged in a liquid vehicle like a mutual fund or ETF.)
Liquid alt funds might invest in assets such as global real estate, commodities, futures, leveraged loans, start-up companies and unlisted securities—all of which offer exposure beyond traditional stocks, bonds and cash. There’s no single definition of alternative investments that make up a liquid alt, or classification of strategies for these funds, so they can vary widely.
The strategies liquid alts employ tend to fall on the more sophisticated, elaborate or complex end of the spectrum. Examples include hedging and leveraging through derivatives, so-called “long-short” strategies and short selling, and "opportunistic" strategies that change with market conditions as various opportunities present themselves.
Some alt funds employ a single strategy (single-strategy funds). For instance, they might focus exclusively on currencies or distressed bonds or might employ a “market-neutral” or "absolute return" strategy that uses long and short positions across assets to generate returns. Others might employ multiple strategies (multi-strategy funds) such as a combination of market-neutral strategies and various arbitrage strategies. Still others are structured as “funds of funds,” which contain multiple alternative funds.
In some cases, a fund's primary objective is to generate above-market returns. In other cases, a fund's main goal is to help investors better manage risk with strategies designed to smooth out volatility or offer greater diversification. It’s important to look under the hood to understand what the objective of a particular alt fund is as well as to get a sense of what kind of exposure it provides and how it does so.
How Do Liquid Alts Compare with Hedge Funds?
Although the strategies and investments of liquid alt funds might bring to mind those of hedge funds, the two should not be confused. Liquid alts are generally regulated under the Investment Company Act of 1940. This limits their operations in ways that don’t apply to hedge funds, which are not registered. These protections include:
- limits on illiquid investments;
- limits on leveraging;
- diversification requirements, including limits on how much may be invested in any one issuer; and
- daily pricing and redeemability of fund shares.
As a result, liquid alts are more limited in the investments and strategies they can use. In turn, the performance and portfolio characteristics of a liquid alt might differ significantly from those of an unregistered alternative investment that has similar investment objectives.
Fees structures can also differ. Unlike their private hedge fund adviser peers, investment advisers to mutual funds, including liquid alt funds, aren’t allowed to charge investors a "2/20" performance fee for advising the fund. Hedge fund advisers often charge a fee equal to 2 percent of the fund's assets, plus 20 percent of gains that the fund produces during a given period.
Before You Invest
Like any investment, liquid alts have their pros and cons. Performance can fluctuate and there’s the risk of losing money. Before you invest in an alternative fund, here are some points to keep in mind:
- Strategy Risk Factors: In addition to the usual market and investment specific risks of typical mutual funds and ETFs, alt funds can carry additional risks from the assets or strategies they use. For example, a distressed bond fund is likely to have significant credit risk, while market-neutral funds tend to have significant portfolio turnover risk that can result in higher costs.
- Investment Objectives: One fund might be designed to capitalize on manager expertise in a specific area—such as investing in distressed companies. Another might seek to provide what the fund's managers believe to be more complete diversification through exposure to commodities, currencies and other alternative investments. Know the fund’s objective and how that product aligns with your overall financial goals.
- Operating Expenses: Alternative funds can be pricey relative to their traditional fund peers. It’s common for alt funds to have annual operating expenses in excess of 1 percent per year, and some funds are considerably more expensive.
- Investment Structure: Some liquid alts—particularly those that primarily invest in futures—may rely on gaining their exposure through the use of a wholly owned offshore subsidiary or affiliate. This might add to investment costs and reduce transparency. An alternative fund of funds might offer greater diversification than a single-strategy or even multi-strategy alt fund. At the same time, this greater diversification might lead to a flattening of return and potentially less transparency, as well as higher or more opaque costs. There might also be an inability to re-allocate or adapt in a way that’s beneficial to the overall performance of a particular fund of funds.
- Fund Manager: Learn as much as you can about the fund manager, such as how long they’ve managed the fund and their additional fund management or professional experience. Research the professional background of a fund manager using FINRA BrokerCheck.
- Performance History: Liquid alts are a fairly new investment type, having largely been launched after the Great Financial Crisis of 2008. As such, they have limited performance histories, making it hard to compare them in a variety of market conditions to broad indexes such as the S&P 500—particularly after considering expenses. However, some liquid alts now have a decade or more of history, so you can get a better sense of how they’ve performed.
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