Liquid-alt funds are designed to be more market neutral than normal funds, promising more protection against bear markets. How well have they done during this last one?
While many people think of the difference between mutual funds and exchange traded funds, or ETFs, is that you can buy and sell shares of ETFs yourself on the stock market, what really separates ETFs from a functional perspective is their not being limited to being all in on the long side.
This difference will really show itself as we move toward more and more actively managed ETFs, which will allow a lot more investors, ones that do not qualify to invest in hedge funds, to get in on this action if they wish.
We’ve already had these sorts of funds for the last 5 years or so, called liquid alternative funds, or liquid-alt funds. While their reach has only grown to a relatively modest $119 billion so far, this category of funds is expected to continue to grow, even among institutions who are migrating away from the real hedge funds toward liquid-alts due to looking to save money on the high fees that hedge funds charge.
Institutional investors already comprise two-thirds of the liquid-alt market, and these ETFs haven’t been very widely promoted in the market and a lot of investors have never even heard of them. They would typically have them recommended by their advisors, in other words be sold on them, and as always, you don’t want to just be holding out your bag and allowing someone else to fill it for you without really understanding what you just bought.
With those familiar with liquid-alt funds, the idea certainly can be made pretty appealing on the face of it. A lot of investors yearn for the opportunity to invest in hedge funds, and object to their being shut out of them just because they don’t make enough money or have enough assets, and when they are shown a backdoor to this venue, they may jump at the chance.
The alternative in liquid-alt ETFs both means an alternative to mutual funds or other long-only funds and an alternative to hedge funds. It is the ability to use liquid-alt funds to hedge that has them stand apart from normal ETFs and mutual funds and is the real meaning of the word alternative in their name.
A big reason why hedge funds are only allowed to be invested in by more well-off investors is the lockup period that hedge funds require. Hedge funds require a commitment where you aren’t allowed to do anything but remain in the fund for certain periods, and if you experience a financial need during this period and you have to rely on cashing in your hedge funds, you can be left stuck. A higher amount of income and wealth makes this scenario less likely.
Hedge funds do benefit from this arrangement, and this is why they require it. ETFs are exchange traded so people do their own trading with them and they are not subject to the potential for lockup requirements, which is where they get the liquid part of their name from.
Liquidity is certainly desirable and important, so this is a real advantage. Another advantage that liquid-alt funds have over hedge funds is their lower fees, and it’s not the management fee that differs so much here, it’s the performance fee that hedge funds charge, where you typically hand over 20% of your returns to the fund manager when you make money from the fund.
It may seem ridiculous that anyone would pay that much for performance, but if what you have left over after all these fees are deducted is still considerably higher than what you see yourself earning with a normal fund, this end up being a real net gain and something that would be welcomed.
These very high rewards to fund managers allow the top hedge funds to attract the very best talent in the business, and why settle for a million or two when you can make so much more at a top hedge fund. Some hedge fund managers have even become billionaires from all this.
It shouldn’t be surprising that hedge funds outperform their poorer cousin, the liquid-alts, net of all fees, but if you want to be in a hedge fund but otherwise cannot, liquid-alts are the only game in town short of your putting together your own little fund. This is well beyond the interest and means of your typical investor, at least without having this strategy greatly simplified for them, which we always seek to do but is so rare in this business, because they want you to leave all of this up to them.
The next question needs to be whether we ever want to be in these funds, and if so, at what times do they make sense to be in as well as how much of our portfolio should we want to commit to this type of investment.
We looked at managed futures in a previous article, which is a type of liquid-alt fund, although like with hedge funds, there are other types, like long/short funds which look to play stocks both ways, or arbitrage funds which look to take advantage of intermarket price inefficiencies.
The goal of hedge funds is to be more market neutral than long-only funds, where the normal risks involved in staying in long positions is sought to be reduced by offsetting some of this risk. This is actually not a good way to approach investing as it interferes too much with the bigger goal of profitability that investing seeks, and to do this right, we need to target our hedging properly.
Seeking more neutrality is actually the undoing of investors generally, because the reason why we invest in stocks is due to their substantial upward bias, and therefore seeking more neutrality means lowering returns substantially.
We Shouldn’t Want to be Neutral, But We Should Want to be Adaptive
What you really want to do with a hedge style fund is understand that the main benefit of this is not to seek to be neutral, but to use the greater flexibility that these funds enjoy to become better aligned with the direction of the market rather than to just try to damp it down.
This is what a good hedge fund does, but a lot of them aren’t so good and most do tend to rely on a fair bit of dampening instead, being short things during a bull market and the like. The more efficient we can align ourselves to the market, the better we will do, and good hedge funds both beat the market with returns and control the risk better, even though going with the market does not control risk at all and that part is pretty easy.
We should not be willing to pay a price in returns for this though and if a fund does not beat the market over time, whether it’s a hedge fund or some other type, this is not what we should ever be seeking.
Liquid-alt funds generally do not control the risk very well nor provide comparable returns to the market, but much of this is due to fund managers not doing a good job at managing their funds. It also can be difficult to turn these funds over very quickly, and the pullback we saw in February and March really showed this, where these funds were caught spinning their wheels while the crash was going on, and there just wasn’t enough time for the bigger ones to get turned around in such a short time and reverse quickly enough as well.
An example of this challenge is how the JPMorgan Hedged Equity Fund Class R6 did over this time, which did manage to contain their drawdown during the crash to just 22%, a loss which they have almost made back now, but one that still stung quite a bit. Compare that to the advice we provided our readers at the time of the collapse, to move into a leveraged treasury ETF, and this was only one day after the crash hit and would have not only avoided almost all of it but would have provided a very nice profit while we watched just about everyone else lose their shirts.
It wasn’t really hard to figure out when to get back in, but this is using a tool that funds don’t normally have, the ability to stop and reverse on the same day, and usually within just minutes for us. Most investors would strongly prefer that they don’t even have to be paying attention, let alone make moves like this, and the biggest price that they pay is that the bigger funds at least are just too big to be able to react like we can.
The JPMorgan liquid-alt fund is one of the better ones out there though, and is both in pretty good shape compared to most funds in the aftermath of this, and has also delivered at least half-different returns over a longer period of time, averaging 5.7% over the last 5 years. This is behind the S&P 500’s 8.6%, but not by a terrible amount like many liquid-alt funds.
Still though, we shouldn’t be giving up return like this, and this almost 3% per year really adds up over time. Similar to hedge funds, there is considerable divergence among liquid-alt funds in terms of performance, and therefore there is a real premium on selecting the right fund, one that will both do better in the bad times as well as the good times.
It Matters a Lot Which Liquid-Alt Fund You Choose
The RiverPark Long/Short Opportunity ETF really showed them how it’s done this time around. Fund manager Mitch Rubin’s goal is to double people’s money every 4-6 years, and while he hasn’t quite achieved that yet, the fact that a fund manager is even shooting for such a thing is the sort of thing we really want to see.
When the panic started to hit, Rubin was ready, and he immediately went to work and shorted hotels, cruise lines, and casinos, while adding to positions in stocks that would do well in this environment such as Amazon. The fund’s maximum drawdown was kept below 13%, and is now up a very nice 18.6% on the year. They still could use some work overall, although they at least have beaten the S&P 500 over the last 5 years, with an average return of 10.2%, meaningfully higher than the S&P’s 8.6%.
With Rubin’s attentive and effective fund management in 2020, we can only wonder how well this fund would do if they relied on their transition game more and became more aggressive during the bull phases of the market. Rubin has really shown a lot of improvement over the last year though, after suffering a larger loss than the market with his fund during the mini-bear market of 2018, and this fund does show some real promise going forward.
The optimal way to play this though, for those who aren’t averse to using a little timing, would be to look to get out of stocks when trouble hits and then look to re-enter with a fund such as Rubin’s, letting it do its thing running down as these funds do, and then jump on when it starts to recover. This wouldn’t have made a lot of difference this time around, but in an extended bear market, this is a fund that can still make hay and deliver positive returns with their ability to short.
What most other liquid-alt funds do is play too much defense when they should be focusing on offense, like the Cambria Tail Risk ETF. While their year to date returns are similar to RiverPark’s, the Cambria has lost money over its 3 years of existence, and that’s definitely not the plan. They invest in treasuries and stock puts, and buying puts in a bull market is not a good idea. This fund actually took a pretty big hit in the first 4 months of 2019 when just about everything else was shooting up.
Many of these funds do very poorly over time, and this is the first thing that we need to be looking at, not so much how they handled the COVID crash. It’s worse to stink long-term than short-term, especially when the smell from the short-term stuff fades as it has. If the stench has been around for years already, we need to smell it and then turn away.
While liquid-alt ETFs don’t require investors to be accredited, they do require that they be informed. While that’s the case with picking any fund, it is especially important with hedge style funds because the approaches that these funds use are anything but vanilla and can vary from mad trading to super cautious, and levels of skill from very impressive to very questionable.
Being informed here also includes our looking to use our strategies well, and not just look for another club in a bag full of clubs. People are generally sold liquid-alt funds in a way that has it take so small of a portion of people’s portfolio, like 5%, to make any real difference either way, and this is due to the sales people getting credit for this and all the other sales that they make to these investors, and for them, the more sales, the merrier.
The advice of buyer beware most certainly applies to buying investments, and anytime that you are less knowledgeable than your salesman, the salesman wins and you may or may not. If we don’t know what we are doing, we will end up with a portfolio that sure looks like we don’t know much, and the worst thing about this is that, knowing little, we won’t even know when it is bad.
Liquid-alt funds are an interesting way to invest, where they can leave the long-only, fully invested requirements of mutual funds behind and jump the fence around hedge funds, but this only works if you are willing to learn enough and to especially think enough, and especially, if you are selective enough and choose well.