Jun 29, 2022
Wall Street Journal: Liquid Alt Funds Head for Record Inflows as Stocks and Bonds Drop
Liquid Alt Funds Head for Record Inflows as Stocks and Bonds Drop. With performance varying widely and fees ranging from 0.5% to 3%, investors are reminded to be careful about due diligence.
The role of bonds as a hedge to stocks is Wall Street canon. When those markets fall in tandem, investors tend to scramble for other, sometimes riskier, forms of protection.
Investors have poured more than $21 billion into liquid alternative mutual and exchange-traded funds this year through May, according to Morningstar Direct. That is on pace to beat last year’s record inflows of $38.3 billion.
Sometimes called hedge funds for the masses, liquid alternative funds allow individual investors to diversify their portfolios using complex strategies, including everything from options to convertible-bond arbitrage. Roughly $192 billion currently sits in such funds, which are commonly referred to as liquid alts, according to Morningstar Direct.
Investors have fled the stock and bond markets this year, with the Fed pushing up interest rates.
The funds lack some of the protection offered by hedge funds, which typically require investors to lock up their funds, allowing withdrawals only at set intervals. That prevents hedge funds from being forced to sell positions rapidly to meet redemptions, which could hurt performance for remaining investors. No such protection exists for liquid alts.
Performance among liquid alts can vary widely, and they carry hefty fees of anywhere from 0.5% to 3%, potentially deterring investors accustomed to more-traditional products that charge less than 0.1%.
This year’s best-performing categories among liquid alts are systematic trend strategies that follow price-momentum by trading futures, options and swaps. The average fund in the group is up over 17%, according to Morningstar Direct.
The KFA Mount Lucas Index Strategy ETF, for example, has risen 38% in 2022 and has attracted $70 million in inflows in the past month, pushing its total for the year to $91 million, according to FactSet. At the start of the year, the fund, which launched in December 2020, had $32 million in assets.
Other funds in the same category are down 10% on the year, according to Morningstar Direct. The average options trading strategy is down roughly the same.
H&R Block is one of the stocks held by a fund pursuing an equity market neutral strategy.
“You need to do your due diligence because the exposures and types of strategies that these managers employ really differ from each other,” said Bobby Blue, senior manager research analyst at Morningstar. “Even within the categories, there’s a wide dispersion, which speaks to the heterogeneous nature of liquid alts.”
Investors have fled both the stock and bond markets this year, with inflation hovering at a four-decade high and the Federal Reserve in the midst of an aggressive move to raise interest rates. The S&P 500 is headed for its worst first half of a year since 1970, down 20%. U.S. Treasury yields, which rise when bond prices fall, are at their highest levels in more than a decade.
The traditional 60/40 investment portfolio, a model consisting of 60% stocks and 40% bonds, hasn’t offered investors protection from the carnage.
“The 60/40 portfolio has been dead; this isn’t new,” said Shana Sissel, founder and president of Banríon Capital Management. “But now investors are starting to realize that they have to think more critically about portfolio construction and diversification, and alternative strategies are one of the bright spots in the market.”
Equity market neutral strategies are one of the categories garnering the most investor interest; more than $960 million flowed into equity market neutral strategies in May, the highest monthly total in more than eight years, according to Morningstar Direct.
One such fund, the AGFiQ US Market Neutral Anti-Beta Fund, is up 20% this year. The strategy shorts, or bets against, stocks in the S&P 500 with the highest beta, or correlation to the overall index, and is bullish on those with the lowest beta.
The fund owns stocks such as H&R Block Inc. and White Mountains Insurance Group Ltd., which have risen 47% and 21% this year, respectively. It has short bets on the payments company Block Inc. and the freelancing platform Upwork Inc., which are both down more than 40%. The fund has recorded nearly $36 million in inflows this year, according to FactSet.
The drawback? The fund charges a 2.53% fee.
“This is still a pricey cohort across the board, but there are some strategies worth the price tag,” said Mr. Blue. “These are sophisticated strategies taking on leverage, which isn’t free.”
Nicolas Rabener, founder and chief executive of FactorResearch, said there is a point at which a fund becomes too expensive to hold. “You should avoid strategies with fees higher than 1.50%; it’s difficult to justify that cost,” he said. “Markets are competitive, and high costs will eat up any excess returns you’ve generated.”
Liquid alts proliferated in the wake of the 2008-09 financial crisis, gaining popularity by giving individual investors access to the market-neutral and all-weather strategies that propelled hedge funds during the recession. Much of the traction was lost in the midst of the stock market’s decadelong bull run that followed.
Whether liquid alts retain their popularity remains to be seen. With the Fed signaling more tightening, stocks and bonds are likely to face more volatility in the second half.
Mr. Blue said he expects the inflows to liquid alts to remain steady for some time but advises investors against chasing their performance.
“If you’re going to allocate to this space, be sure to understand why you’re doing it,” he said. “It’s for the diversification benefits; it’s for the long term.”