Global Head of Alternatives
Hedge funds for everyone: the rise of liquid alternatives
While equities are often seen as the pre-eminent growth investment, investors have long recognised the benefits that “alpha” (excess risk-adjusted return) can bring to an investment portfolio. For many years, hedge funds claimed the mantle as the ultimate source of alpha. Hedge funds are unconstrained by benchmarks, able to invest in instruments avoided by traditional asset managers and are experienced in using derivatives and, occasionally leverage (using financial instruments or borrowing to increase returns), to capture opportunities that others find hard to reach. Attracting some of the brightest talent, the hedge fund universe continues to boast some compelling investment opportunities.
But hedge funds can also seem like hard work for investors. They have historically been lightly regulated and less liquid and less transparent than traditional equity and bond funds. The financial crisis provided the press and politicians with the headlines they love – examples of hedge funds failing to hedge, fraudulent activity (Bernard Madoff) illustrating the dangers of limited regulation, and the opportunity to blame short selling (selling a security that is not owned) for accentuating market falls. As a result, the relationship between hedge funds, investors and their regulators has changed markedly over the last few years. We have become less forgiving of hedge funds’ weaknesses, and have challenged fees and transparency, in particular.
Yet the alpha that hedge funds can provide remains compelling. With the help of the academic community, the understanding of hedge fund alpha – and the repeatability of the returns that can be generated without reliance on the equity markets – has increased markedly. Given the current precariousness of both equity and bond markets, the differentiated sources of growth that can come from this type of “alpha” is particularly attractive today. It’s not surprising therefore, that new ways to access that alpha have emerged.
Liquid alternative strategies have seen rapid growth, with assets under management multiplying five-fold since 2008. These funds offer hedge fund strategies in a regulated and transparent format. In the US, these funds come in alternative mutual fund ('1940 Securities Act' or just ‘40 Act’) wrappers and in Europe, in UCITS (Undertakings for Collective Investments in Transferable Securities) wrappers. They must adhere to the same regulatory requirements as traditional equity funds on liquidity, diversification and leverage, although short selling and the use of derivatives are allowed. Investors have significantly more security-level transparency and redemptions are possible in days, rather than weeks or months. Perhaps most importantly, they provide a route to many of the sources of alpha that hedge funds look to capture.
While not every opportunity from the hedge fund space can be replicated in a mutual fund or UCITS structure, a range of diversifying strategies can be accessed. For example, using liquid derivative contracts, global macro funds hold long and short positions across asset classes in order to benefit from global trends and country specific market dynamics. Relative value strategies take simultaneous long and short positions in similar securities to benefit from corrections in their price differences. Long/short equity strategies seek to capture the relative returns between stocks based on their fundamental analysis.
Investors should remember, however, that it can be difficult to consistently generate alpha, even in strategies that should provide good opportunities to access it. This means that thorough and effective due diligence and monitoring of managers is critical in the liquid alternatives space. It also means that an actively managed portfolio of strategies is likely to be a more reliable route to long-term returns. Indeed, some of the best liquid alternative strategies are only available via a manager-of-manager structure as hedge funds look to access the space while limiting their own regulatory and reporting burden.
Liquid alternatives provide a new route to alpha, and investors can benefit from the diversification potential these strategies can provide. With the future direction of the equity markets uncertain, that can only be a good thing for investors.
Andrew McCaffery, Global Head of Alternatives