Mutual funds using hedge fund strategies expand access to alternative investing. As their name implies, alternative mutual funds aren’t conventional investments.

Unlike Other mutual funds, whose primary strategy is to purchase securities for their portfolios, alternative funds may, to the extent they’re able, sell short, but futures contracts or currencies rather than securities, use options contracts to offset risk, or borrow to deliver higher returns.

In other words, alternative funds use some hedge fund strategies. At the same time, they limit exposure to some, though certainly not all, hedge fund risks.

Liquid alts meaning

For all their differences alternative funds are still mutual funds and must operate in compliance with SEC regulation that:

  1. Require transparency, disclosure, and daily calculation of net asset value (NAV).
  2. Forbid performance fees.
  3. Limit the use of leverage and illiquid investments.

As with all open-end mutual funds, you can redeem shares in alternative funds any time at the end-of-day NAV — hence the name liquid alts. And there are no restrictions on who can buy shares in these funds.

liquid alts diagram

All you need is enough money to make the initial investment, which typically requires thousands, rather than hundreds of thousands, of dollars.

Inside an alternative fund

Liquid alts may be a bond, equity, or commodity funds. The primary objective of a bond fund is to hedge a portfolio against the impact of changing interest rates. Long/short equity funds focus on minimizing the impact of a falling market, while market-neutral funds seek to provide a positive return whether the market goes up or down.

Other strategies, including macro global event-driven, as well as managed futures funds, seek results based on their particular focus. Single-strategy funds typically have a single manager and one investment approach. Multi-strategy funds, on the other hand, have a number of advisers, each managing a portion of the overall portfolio using a different investment approach. The built-in diversification of multi-strategy funds may be more efficient and cost-effective than selecting a number of single-strategy funds.

The appeal of liquid funds

A liquid alt’s primary attraction is portfolio diversification. That’s because the return is characteristically noncorrelated with the return of a buy-only strategy.

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So adding a liquid alt has the potential to reduce the overall volatility of your portfolio and to provide downside protection in a falling market. Of course, neither is guaranteed. Liquid alts are sometimes promoted as providing higher returns than traditional funds. But their ability to outperform is much more limited than it is for the hedge funds they emulate. The reason is that hedge funds can do things that funds can’t, such as using leverage and loading up on illiquid investments when they’re extremely cheap, anticipating substantial returns in the long run. In contrast, only 15% of an alt fund’s portfolio can be illiquid at any one time.

The jury is still out

A complicating factor in evaluating liquid alts before you invest is that they’re relatively new products, most having been introduced since 2008. So there’s not enough data to know how effective managers are in meeting their objectives. Early results indicate that returns are widely divergent, with
some managers having far stronger track records than others, particularly in market downturns.

Most liquid alts are sponsored either by an investment company that also offers traditional mutual funds or by a hedge fund company, sometimes in partnership with an investment company.

Two benchmark indexes specific to liquid alts that were launched in 2014 should help in evaluating these funds’ relative returns. Interim benchmarks, including the SP500 and some hedge fund indexes, weren’t necessarily appropriate, given the significant differences in strategy. It’s also likely that the benchmarks will serve as the basis of new index products, including index mutual funds and ETFs.

Advantages and disadvantages

With liquid alts, as with all investments, there are advantages and potential drawbacks. On the plus side, you can invest in a liquid alt for much less than you can in a hedge fund, both in terms of upfront costs and ongoing fees. In addition, you will have access to more information about the liquid alt and will find it easier to redeem your shares.

However, the fees that you pay are substantially higher than those on traditional mutual funds. In fact, when all the charges are tallied, the cost of liquid alts typically amounts to 3% to5% annually. That’s substantial enough to take very seriously in deciding whether or not to invest.

According to the SEC an illiquid asset is one that can’t be sold within seven business days for a price equal to the fair market value that has been assigned to it.

Another issue is how well you understand what you’re buying. While some strategies, including long/short, are fairly straightforward, others are not. An approach that depends on assessing the impact of potential changes in world markets, as a global macro strategy does, might give you pause. As a result, these investments require even greater initial investigation and more continuous monitoring than traditional funds.

There is a question, too, about what percentage of portfolio you should allocate to alternatives. It may turn out that you need to commit 15% to 20% rather than a more modest 5% to 10%, to impact your overall return. Taking a conservative approach to alternative investment, which seems like a reasonable position, may actually not be worth the effort — or the cost.

Liquid Alternatives Definition, Examples, And How it Works? by Inna Rosputnia

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