As their name states, hedge funds are designed to hedge risk against volatile markets, providing a key source of portfolio diversification. Hedge fund managers rely on managed futures contracts, long/short portfolios, trend-following strategies, global macro funds and infrastructure investments to broaden portfolio exposure beyond the stock/bond axis.
Financial advisors can adopt the very same tools in a category of liquid alternative funds (commonly referred to as liquid alts). These funds initially attracted a burst of attention after the 2008 financial crisis but have faltered in the past decade as stock prices marched steadily higher.
Yet with geopolitics rolling global markets, hedging has started to pay off. Against a backdrop of heightened stock and bond volatility, the average hedge fund, which can be considered a key proxy for liquid alts, has returned 6.9% through August, according to BarclayHedge. However, for most of this year, investors have pulled money from hedge funds, particularly macro funds.
Liquid alternative funds aim to deliver positive absolute returns in most market conditions, and more importantly, possess little correlation to stocks and bonds. As Bill Kelly, CEO of the Chartered Alternative Investment Analyst Association (CAIA) notes, liquid alts “tamp down volatility in a portfolio and provide an important form of diversification.”
And Kelly asserts that the current market backdrop may be ideal. “There is a sense that the extended ‘risk-on’ phase of the stock market may be nearing an end,” he says.
For those completely unfamiliar with liquid alts, Kelly’s firm provides various educational platforms for advisors to get up to speed. The firm has been offering a “core credential” curriculum for nearly two decades. Requiring roughly 400 to 450 hours of studying, it is primarily aimed at institutional investors.
For advisors, the CAIA offers a slimmed down 23-hour set of course modules that cover industry fundamentals for key alts. Kelly says the coursework helps advisors “think like asset allocators, across the risk premium spectrum.”
Matt Osborne, chief investment officer at Artivest, which oversees the Altegris family of liquid alt funds, notes that a number of advisors he works with “are as skilled as institutional investors,” but cautions that smaller advisors may not be as well-equipped to appreciate the merits and mechanics of the approach.
“The education process (for advisors and their clients) is a continuing challenge,” he says.
Take the Altegris Futures Evolution Strategy Fund (ticker: EVOAX) as an example. To understand how this fund operates, an investor needs to know the basics of a managed futures investment strategy. This approach calls for the purchase (or sale) of futures contracts on any assets (such as currencies, equity and bond markets, commodities, etc.) that are in a technical trend, either up or down.
The EVOAX fund builds on that approach, adding a fixed-income sleeve to the portfolio with input provided by sub-advisor DoubleLine Capital.
Morningstar tracks liquid alts funds and has identified top-performing funds that merit the firm’s four and five-star ratings. The EVOAX fund, for example, garners five stars, and has gained a solid 8.6% year-to-date.
Long/short equity funds are another category that advisors can tap into during these uncertain times. The Weitz Partners III Opportunity Fund (WPOPX) earns five starts from Morningstar and has delivered an impressive 24.8% return thus far in 2019. The fund is mostly concentrated in long investments in blue-chip firms like Berkshire Hathaway, Liberty Global and Mastercard, offset by a smaller portfolio of short positions in firms with more challenged outlooks.
Some liquid alts funds combine several strategies into one basket, such as the Blackstone Alternative Multi-Strategy fund (BXMDX), which works with a range of high-profile sub-advisors like D.E. Shaw, IPM and Two Sigma. The fund, which is the largest multi-strategy fund with $8 billion in assets, invests in risk arbitrage, global macro, thematic trends, and other alternative categories.
However, the fund, up 4.1% year-to-date, also carries an eye-popping 3.28% expense ratio. Many other liquid alts funds charge 1.5% to 2.5%, which is still a fairly stiff price of admission. Artivest’s Osborne says the fees associated with liquid alts funds reflect the expertise (and costs) of knowledgeable sub-advisors.
As of now, there are few ways to invest in liquid alts in the form of lower-cost exchange-traded funds (ETFs). The $884 million IQ Hedge Multi-Strategy Tracker ETF (QAI) is one of a handful of examples and its 0.80% expense ratio is a relative bargain.
To be sure, liquid alt funds are no match for a bull market. The implicit nature of their hedging strategies means they will be more tortoise than hare. Yet after such a long run, once the bull’s legs start to wobble, if not buckle, portfolio hedging through these funds may help clients preserve their wealth.
David Sterman, CFP, is President of New Paltz, NY-based Huguenot Financial Planning