Alternative funds provide little benefit to most investors

I was recently asked to review a portfolio for a client of a traditional Wall Street brokerage firm. While there were traditional stock and bond funds in the portfolio, there also were a number of funds that fell under the category of “alternative” funds or “liquid alternatives” (aka liquid alts).

Liquid alt funds became popular after the 2008–2009 market downturn as a way, in theory, to provide increased diversification to a traditional stock-bond portfolio and reduce the risk of the portfolio during market downturns. Liquid alts are often promoted as hedge fund-type strategies made available to the mass investing public. They include such fund categories as long-short funds, commodities, market neutral, managed futures, multialternative, and options strategies. 

But do such funds really improve the risk-adjusted performance of a traditional stock-bond portfolio?

Like many new ideas promoted by Wall Street, the reality hasn’t lived up to the hype. The results have not been good, investment research firm Morningstar concluded in a study of liquid alts.

“For investors who turned to liquid alternatives to help broaden their portfolio’s diversification after the financial crisis, it has often been the part of the portfolio that’s been more disappointing than not,” Morningstar wrote.

Morningstar ran a series of tests to determine if liquid alts would have improved the risk-adjusted return of a traditional 60 percent stock-40 percent bond portfolio. According to their research, most funds failed to improve a traditional stock and bond portfolio over three- and five-year periods ending Dec. 31, 2017. 

Recognizing that past performance doesn’t guarantee future results, Morningstar does note that “this doesn’t mean that liquid alternatives can’t potentially help portfolios over the next three and five years. But so far, they haven’t been as helpful as many investors probably expected.”

Another study, conducted by the CFA Institute, concluded that while an allocation of 20 percent to liquid alt funds provided better risk-adjusted performance when added to a standalone S&P 500 (500 largest U.S. stocks) portfolio for years 2002–2018, liquid alts did not provide better risk-adjusted performance compared to adding 10-year U.S. treasury bonds instead. In other words, traditional U.S. Treasury bonds provided better risk-adjusted performance than liquid alts. 

“Investors should be wary of liquid alternative funds that offer equity exposure at high fees and effectively represent fake alternatives,” the author wrote.

It’s not unusual to see funds in this sector that have high fees and poor returns. Expense ratios can be 2–3 percent, which is very high. Average annual returns for many of these funds since inception can be 1 percent or less. During the recovery of markets since 2008–2009, stock and bond markets had significant positive results. An investor in many of these funds concerned with volatile markets would have probably been better served holding a very conservative portfolio of stocks and bonds — or even cash in a time of historically low interest rates.

I see this story being repeated consistently — i.e., expensive funds with low returns being promoted to “solve” the “problem” that markets sometimes go down. The big appeal of liquid alts, in theory, is the downside protection when markets are declining.

This is the sales pitch for those selling such funds and it is the fear that motivates those buying them. Like many Wall Street products, the problem being solved with liquid alts is a behavioral and educational issue and shouldn’t be a product issue. 

With a little education, most investors should understand that risk and return are related. An investor can’t enjoy returns greater than cash without taking some additional risk. In fact, market corrections — sometimes severe corrections — are a feature of successful long-term investing, not a “bug” in the system that needs to be fixed.

Reacting emotionally can lead to emotional decisions.

A trusted financial advisor can help an investor develop an appropriate portfolio mix of stocks and bonds that meet the investor’s risk tolerance while planning for market fluctuations.

According to Morningstar, about one-third of the managed-futures, multialternative, long-short equity, and market-neutral funds have liquidated and closed over the past five years ending May 31, 2018. Perhaps the investing public should take a careful approach until such strategies can be proven to provide better risk adjusted returns than traditional portfolio hedges, such as diversified bonds.

Dean T. Stange, JD, CFP, is a principal and senior financial advisor at Wipfli Financial Advisors LLC.

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