The ‘Problem’ with Liquid Alternatives – in one nice Table

Date: Friday, August 9, 2013
Author: Attain Capital

Adding ‘alternatives’ to your portfolio has never been as easy as today with the plethora of so called ‘liquid alternatives’, or mutual funds specializing in alternative investments such as mutual funds. And the marketers have never had such an easy time separating the naive from their money in their bids to raise money for these funds.

Enter an old five-pager by the Principal Group we just dug up which explains how to utilize 15 different hedge fund strategies in portfolio construction. It has all you would ever need to know about these highly complex investments, dedicating 4 to 6 sentences to each one! (are you picking up the sarcasm) For example, thinking about managed futures in your portfolio, here’s all you need to know:

 • Intended Effect on Portfolio =  Diversifier

• Definition = Commodity Trading Advisors (CTAs) trading commodity, currency, and financial futures typically using trend-following models and sometimes fundamental economic analysis.

• Expect to work best when = Should perform well in adverse market conditions for stocks and bonds.

• Expect to work worst when = Generally performs worst in markets that are directionless and have no lasting trends.

• Outlook = Positive outlook – Macroeconomics are dominating capital flows and valuations, which should provide good opportunities to these managers.

• Tracking Index = The HFRI Macro: Systematic Diversified Index includes strategies that have investment processes typically as a function of  mathematical, algorithmic, and technical models, with little or no influence of individuals over the portfolio positioning.

That’s all you need to know? So much for the Chartered Alternative Investment Analyst designation or decades of experience with the asset class. Just grab the nifty cheat sheet here and start building portfolios. Sure, there are some managed futures mutual funds which don’t even invest in managed futures. Yes, there are some which employ strategies that should not perform well in a crisis – but you understand the basics, and the funds say ‘managed futures’ on the label… what could go wrong?

What could go wrong indeed – how about mismatched performance with investor expectations, high fees,  poor relative performance to benchmarks, a concentration in the largest managers which deal mainly in financials, counterparty risk, credit risk, and the propensity of the correlations and relationships listed all blowing up during a crisis.

I guess we shouldn’t be surprised when FINRA put the responsibility on the investor, not the marketer of these products, to make sure they know what the product is doing. But still… this quick synopsis strikes us as all that is wrong with the mutual fund wrapper for alternatives, just glazing over reams of complexity with easily comprehensible talking points like the following from the piece:

[Alternatives Can…]

• Enhance portfolio diversification. When alternative strategies are added to a traditional diversified portfolio of stocks, bonds, and cash, they may help investors achieve broader portfolio diversification as well as potentially create more efficient portfolios due to their expected low, or even negative, correlation with traditional assets.

• Produce consistent returns over time. Combining alternative strategies with traditional portfolios has the potential to generate attractive returns over time through a variety of market conditions.

• Preserve wealth over time. Because alternative investments seek low correlation with traditional assets, they may help to preserve wealth when stocks and bonds are out of favor.

Marketers, take note, this is how you sell a complex idea to unsophisticated investors. Unsophisticated Investors, take note, it’s a lot more complex than this!