The Growth of Liquid Alternatives and the Importance of Thorough Due Diligence
By Cos Braswell & Peter Girard
As equity and fixed income markets have struggled in 2022, investors have taken a taken a greater interest in alternative asset classes. Areas such as hedge funds, private equity, real estate, and private debt have captured more attention due to their ability to provide a different risk/return profile relative to equities and high-quality bonds. Unfortunately, these asset classes typically require high minimums which makes them difficult to access. However, we have seen tremendous growth in the liquid alternative space through mutual and interval fund offerings that allow investor the opportunity to allocate to these areas of the market at low minimums with reasonable fees and liquidity. When identifying liquid alternative managers, the due diligence efforts should be thorough. This space has many robust options but there are still numerous funds that have not only quantitative but also qualitative issues that should be identified before making an allocation. Therefore, when investing in liquid alternative managers it is paramount to understand the intricacies of each strategy.
In order to identify the most high-quality managers in the liquid alternative investment space, it is important to focus on the following characteristics:
Team – the key decision makers within the liquid alternative space must have experience managing this type of strategy. At times, there are liquid alternative managers who have an unproven track record and have never managed a liquid alternative strategy previously. For example, some long only equity managers have initiated liquid long/short equity strategies without any experience. It is important to identify these issues early in the due diligence process.
Philosophy and Process- liquid alternative strategies especially in the hedge fund space are investing in numerous asset classes to generate strong relative returns in any market environment while limiting risk. However, these strategies are complex and must be fully understood which involves in many cases performing on-site due diligence. By meeting with the team and reviewing the details of their investment philosophy it helps determine whether an allocation makes sense. For example, LJM was a liquid alternative manager that ran an equity options strategy that had historically strong performance. However, we visited their offices and after meeting with their team and thoroughly reviewing their fund we decided to pass due to the complexity of the strategy and its potential risks. Interestingly, a year later in 2018 the fund had a margin call due to a significant drawdown and was forced to fully liquidate. Overall, this exercise proved the importance of performing in-depth due diligence even on liquid alternative managers.
Fees – the liquid alternative space tends to have higher fees relative to traditional equity and fixed income strategies. However, it is important that fees are fair relative to peers. For example, in the private equity space there are some reputable funds that charged management fees in excess of 3%. The average fee in the liquid private equity space was around 2%. Therefore, these funds were unappealing due to the exorbitant fees they were charging relative to their competitors.
Performance – many liquid alternative strategies have a short-term track record and have never gone through a full market cycle. Therefore, it is important to find strategies that have a longer history and have proven their worth during downturns or significant volatility. Overall, it will eliminate any potential surprises going forward.
Terms – liquid alternatives have terms that vary across the different asset class categories of hedge funds, private equity, real estate, and real assets. Some strategies are offered in a mutual fund structure and offer daily liquidity while others are interval funds that provide quarterly or even semiannual liquidity. When allocating to this space understanding the terms in advance is essential considering some of these managers have the ability to gate their funds if they see substantial redemptions.
Assets Under Management – the amount of assets in liquid alternative strategies is key in determining whether to make a potential allocation. A majority of these funds have minimal assets and a small amount of investors. Even if the strategy is run by a reputable alternative manager the size and investor base is important considering some of these managers may have to liquidate or wind down their fund if assets don’t increase over time.
Valuation Methodologies – some liquid alternative strategies have the ability to invest in asset classes that are not valued on a daily basis. Some examples include private debt, real assets, and real estate. In this case it is essential to understand how they securities are valued and what vendors are utilized to assist in valuing the portfolio. Unfortunately, these items were ignored when investors were allocating capital to Infinity Q, which was a liquid alternative manager. In February 2021, Infinity Q was charged by the SEC for manipulating their pricing models on some of their underlying investments in Credit Default Swaps and Over-the-Counter (OTC) options. The Chief Investment Officer was charged for alternating these figures. This behavior led to his termination and the eventual liquidation of the fund.
Alternative investments have garnered substantial interest and have become a more essential part of portfolios. Adding to different asset classes such as hedge funds, private equity, private debt, real estate, and real assets has the potential to improve the risk and return profiles of portfolios, especially relative to a more traditional equity and fixed income portfolio mix. Liquid alternatives are an area that has gained the most momentum due to lower minimums, fees, and reasonable liquidity. However, allocating to this space still requires substantial due diligence efforts in order to find top-tier talent in a continuously growing space.
Figure 1: Asset Flows into liquid alternatives strategies in 20211
1 Source: Liquid Als in 2021: Record AUM, Strongest Flows in Since 2013 – and Performance to Believe In. https://www.calamos.com/blogs/investment-ideas/liquid-alts-in-2021-record-aum-strongest-flows-since-2013-and-performance-to-believe-in/