Look before you leap into liquid alts

Just as the time to buy homeowner’s insurance isn’t when the once-in-a-lifetime floodwaters crest the threshold of the front door, the time to insure client portfolios against declining stock prices or rising interest rates isn’t when stocks are falling and rates are rising. With stocks continuing to trade at record highs and Federal Reserve Board Chairman Janet Yellen reminding everyone that rates will indeed go up, perhaps sooner rather than later, now might not be a bad time to layer in some insurance into client portfolios.

The hottest ticket financial advisers are chasing to get that insurance is liquid alternatives, which are mutual funds comprising hedge fund strategies.

The name sounds sexy and cutting-edge, but that alone doesn’t mean these investments are for everyone. And it doesn’t mean that advisers can skip their due diligence.

That said, the growth of liquid alternatives can’t be ignored.

In 2004, 116 distinct mutual funds were categorized as alternative, and collectively, they held less than $22 billion in assets, according to Morningstar Inc.

Today about 429 funds across multiple alternatives categories exist, and they have more than $144 billion in assets combined.

So there are plenty of products on the market.

Growth in the use of liquid alternatives from a fund flows perspective is equally dramatic.

Last year, net inflows into liquid alternatives nearly tripled to $40 billion, from $14.6 billion in 2012. The flow has continued this year, with net inflows exceeding $8.5 billion so far.

Both Morningstar and the Investment Company Institute are grappling with how to handle this flood of newfangled mutual funds.

For its part, the ICI last month reclassified open-end mutual funds, a move that it makes every 10 to 15 years, to “modernize” its classifications.

ALTS OBJECTIVE

Most notably, the fund industry trade group added an alternatives objective to four categories of mutual funds: domestic equity, world equity, hybrid and multisector bond.

As Rick Lake, portfolio manager of the Aston/Lake Partners LASSO Alternatives Fund (launched in 2009) put it: “Liquid alts may prove to be the iPhone of the alternative investment world.”

But unlike the iPhone, which doesn’t require users to know much, if anything, of how the technology inside works, liquid alternatives require not only that advisers know how these tools work but that clients know how they work, as well.

Advisers don’t necessarily need to know such intricacies as the individual stocks or bonds being bought, sold or shorted within a liquid-alternatives strategy, but they do need to have a decent level of understanding of the strategy being employed. They need to know, for example, what a long/short strategy is, what an event-driven strategy is and how a high-powered-sounding global macro strategy works.

Once their understanding is up to snuff, they need to educate their clients using plain English and clear examples, not jargon and a pile of meaningless numbers. Beyond the strategies, advisers need to do their due diligence on the funds themselves, from the fund companies to the fund advisers and, finally, the fund managers.

How long has the manager been working in the alternatives area?

What about the fund company? How often has it changed strategies (i.e., does it employ the hot strategies of the moment or does it stick with what it knows through good times and bad)?

MANAGER RESEARCH

Portfolio manager research is always important, but with alternatives mutual funds, it is paramount.

Why?

“It’s a generalization, because there are some decent portfolio managers out there, but I don’t believe the mutual fund space is jam-packed with rock star hedge fund managers,” John Shearman, chief executive of financial advisory firm IV Lions, told InvestmentNews’ senior columnist Jeff Benjamin.

Performance also is important, and here is where advisers could have a better chance separating the liquid-alternatives wheat from the chaff, because many funds have yet to establish long-term track records.

Alas, it isn’t that simple. In fact, this area is where Morningstar is grappling, and that fact alone shows that performance can be valuable only when considered in the context of the strategy, the fund manager and the fund company.

Only when a top-to-bottom review is completed can an adviser invest in a liquid-alternatives fund knowing that it will meet his or her objective in client portfolios. And only when that review is clearly communicated to clients should advisers even think about carving allocations to alternatives.