Defining Liquid Alternatives

Defining Liquid Alternatives

Liquid alternative investments (or liquid alts) are mutual funds or exchange-traded funds (ETFs) that aim to provide investors with diversification and downside protection by being exposed to alternative investment strategies. The point of sale for these products is that they are liquid, which means that they can be bought and sold daily, unlike traditional alternatives that offer monthly or quarterly liquidity. They have lower minimum investments than a traditional hedge fund, and investors do not have to meet the equity or income requirements to invest.

Critics argue that the liquidity of the so-called liquid alts will not hold up under more difficult market conditions; most of the capital invested in liquid alts entered the market during the post-financial crisis bull market. Critics also argue that the fees for liquid alternatives are too high. For promoters, however, liquid alts are a valuable innovation as they make the strategies used by hedge funds accessible to individuals.

Break down liquid alternatives

Liquid alts aim to offset the disadvantages of alternative investments by offering investors exposure to alternative investments through products that can be redeemed daily, much like a mutual fund.

An alternative investment is a vaguely defined term which, in principle, refers to almost any asset which is not a long term action or a bond. Examples include the fine arts, private equity, derivatives, commodities, real estate, distressed debt and hedge funds. One of the drawbacks, however, is their lack of liquidity. Under normal market conditions, a $ 5,000 position in Alphabet Inc. is fairly easy to unload in milliseconds without affecting the price. However, even if the private equity market is in poor health, it will take much more time and effort to sell an alternative investment, and there may be periods of deadlock. It can also be more difficult to take a small position in alternative investments.

Liquid alternatives review

The number of liquid alternative funds has exploded since the financial crisis that began in 2007, as individual investors and advisers are more and more eager to protect themselves against the downside risk by using hedge fund strategies. In a July 2020 survey, Barron’s and Morningstar found that 63% of advisers plan to allocate more than 11% of their portfolios to cash over the next five years. Since then, however, the liquidity market has experienced an influx of closings and consolidations of funds, resulting in a period of slower growth in the market, which reached a size of $ 192 billion, measured by assets, at the end of 2020. market growth remained inconsistent and, according to Strategic Insight, liquid alternative assets rebounded to $ 184 billion at the end of the third quarter of 2020, up from $ 179 billion at the end of 2020.

Critics point out that liquid hedge funds charge higher fees on average than other actively managed mutual funds. Second, putting illiquid assets in liquid packaging can backfire. Hedge funds generally require investors to agree to withdraw funds only quarterly or annually. The ability to trade and sell liquid securities has contributed to their popularity, but if a downturn precipitates a rush for funds, providers may be forced to sell assets at sharply reduced prices, and investors may suffer.

Examples of Liquid Alt strategies and categories

In September 2020, Morningstar defined 12 categories of liquid alternative strategies. The most important, representing more than 80% of the funds at the time, were:

  • Long-short actions: Funds that focus on equity securities and derivatives and combine long positions with short bets made through ETFs, options or short positions in common stocks. The balance of short to long positions will depend on the macroeconomic outlook for the fund.
  • Non-traditional link: These funds take unconventional approaches to bond investing, often trying to get returns that are not correlated with the bond market. “Unconstrained” funds invest with a high degree of flexibility, taking positions in high yield external debt, for example.
  • Market neutral: Funds that seek to minimize systematic risks arising from overexposure to specific sectors, countries, currencies, etc. They aim to match short positions with long positions in these areas and achieve a low beta.
  • Futures managed: These funds invest primarily through derivatives, including futures and forward contracts, options, swaps and foreign exchange contracts. Most use dynamic approaches, while others follow a mean reversion or other strategies.
  • Multialternatif: These funds combine different alternative strategies, such as those listed above. They can have fixed allocations to define strategies or vary their approaches according to market developments.

The other categories include the bear market, multiple currencies, volatility and leveraged commodities (the latter includes a single fund). Citi has listed three different types of mutual fund structures that classify as liquid alternatives: single manager funds, multi-alternatives and commodity funds (or managed futures). Meanwhile, Goldman Sachs has designed a different set of categories that more closely approximate the strategies commonly used by hedge funds. Goldman has divided its universe of liquid alternative funds into long / short stocks, tactical / macro trading, multi-strategy, events and relative value approaches.

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