Dec 20, 2022
Even the most diversified portfolios took their lumps in 2022, but one corner of the market is ending the year with a bang: liquid alternative funds.
The S&P 500 lost nearly 20% this year, while bond yields have soared amid falling prices. Even the iShares Core Growth Allocation ETF (AOR), which reflects at 60/40 portfolio allocation split between stocks and bonds, has shed 16% in 2022.
The story is a different one for so-called liquid alts. These mutual funds and exchange traded funds offer investors some diversification – and in a year as brutal as this one, an opportunity to capture some gains.
“I think what we’ve seen in this period of time is that more people are starting to see the value in liquid alts as a diversifier in an overall portfolio,” said Shana Sissel, president and CEO of Banríon Capital Management.
Major winners in the liquid alts space include the AQR Managed Futures Strategy HV Fund (QMHIX), which popped 36% in 2022. The Arrow Managed Futures Strategy Fund (MFTFX) jumped 21%, while the AGFiQ U.S. Market Neutral Anti-Beta Fund (BTAL) leapt 18% this year.
Investors should resist the urge to treat these offerings as a mere trade, though. Liquid alts can bring higher costs and complexity to investors using them, and they won’t always offer blockbuster performance.
“Once you’ve determined you want one of these in your portfolio, you can’t time it and you can’t just move out,” said Simon Scott, director, alternatives ratings, global manager research at Morningstar.
Different flavors of alts
It’s been a strong year for a particular flavor of alts: systematic trend funds, which use long-short strategies and span across a range of assets, including currencies and commodities. This includes the AQR Managed Futures Strategy HV 1 Fund, which invests in a variety of futures contracts, including those linked to equity indexes and commodities. These types of funds use trend-following and price-momentum strategies, and they enjoyed a boost from trends in commodity prices and currencies this year, Scott said.
Other alternative funds aim to manage downside risk with options, but also provide an opportunity for appreciation. For instance, the Core Alternative ETF (CCOR), which invests in a combination of equities and options, is up about 1.8% in 2022.
“It’s a pretty diverse landscape of different types of products, and what works now might not work a year from now,” said Sissel. She recommended that investors consult a financial advisor when dealing with these funds.
Another issue is determining how much of your portfolio should go toward these funds. Sissel has recommended an allocation of up to 20% in liquid alternatives. That might mean taking 80% of a $1 million portfolio and investing it in a 60/40 allocation toward stocks and bonds, and putting the remaining 20% in liquid alternatives.
Don’t forget performance and fees.
Not only do investors have to figure out which style of alternative fund best suits their long-term goals, they also need to keep an eye on their costs.
Expense ratios for liquid alternative offerings can surpass 1%, as the strategies use margin and derivatives, which can add to the funds’ costs.
Investors should also be aware of how these strategies have fared in different markets.
Consider how the Arrow Managed Futures Strategy Fund is up 21% in 2022, but was basically flat last year. In 2020, it lost 4.1%.
It may be tempting to bail when these alternatives come short, but the variability in performance is just part of the package if investors wish to smooth out returns for the long run. Morningstar’s Scott pointed to three key points for investors to weigh: Why are they considering alternatives? Which strategy works best for their individual set of circumstances? Can they stick with it?
“It needs to be a structural mindset: that you’re holding this for a smoother path over the long term,” said Scott. “Alts are for life, not just for Christmas.”