Liquid Alternatives

Brandon Thomas,co-founder, managing director and chief investment officer of Envestnet PMC, wrote a column that recently appeared in Investment News.  He writes about investing in exchange traded securities representing alternative portfolio management strategies.  Without coming out and saying it, he is describing publicly traded hedge funds.

Liquid alternatives are not new.  Real Estate Investment Trusts have been traded since the 1960s.  Exchange Traded Funds investing in commodities have been around since the late 1990s.  Funds using some hedge fund strategies have had their units traded in other markets, particularly the UK. 

I presume that Mr. Thomas is referring to the growing list of ETFs that are designed to track an index intended to replicate a hedge fund strategy.  All of the strategies invest primarily in liquid instruments, so they should translate to exchange trading fairly well.

Three factors will have a negative influence on these funds' ability to provide the performance that investors expect.  First, providing liquidity to previously illiquid investments revealed that the low volatility and non-correlation of returns was actually just a function of relatively infrequent valuation.  For example, REITs have shown correlations of returns on the order of 60% to 80% of the stock market, despite studies suggesting that real estate has only 20% of the volatility.

On a largest note, the fee structures of hedge funds are very large compared with mutual funds.  This may end up being a vary large drag on the returns of even successful strategies.

The last factor is the hardest to analyze.  Hedge funds are particularly susceptible to "fat tail" risks, rare occurrences of performance events of a very large magnitude.  These events are what catch the headlines for a Paulson on the upside or Amarind or Long-Term Capital Management on the downside.  And while, these ETFs are based on an index of funds, providing some diversification, a large adverse event can have a significant effect on the return of the index.

In sum, the liquid alternatives are worth the interest being generated.  But like the hedge funds they are emulating, they deserve a careful understanding of the strategies, and close scrutiny on an ongoing basis.