From the July/August 2014 issue of Futures Magazine • Subscribe!

Will liquid alts’ performance sustain future asset flows?

Forget questions about whether liquid alternative funds are here to stay. The surge of inflows to liquid alternative funds suggests that debate is over.

According to McKinsey & Company projections, inflows to liquid alternative funds will reach $900 billion by the end of 2015. That surge is likely coming at the expense of traditional hedge fund investments. 

A study by Barclays Prime Services shows that capital flows into liquid alternatives—also known as hedge-like mutual funds—are outpacing dollars going into hedge funds. Liquid alternatives grew by 43% last year, while hedge fund assets increased by 15%. 

Liquid alternatives are the fastest growing category of ’40 Act structures, even though they comprise a tiny part of the mutual fund industry. Recent data shows that the amount of capital controlled by alternative ’40 Act structures stands at $154 billion, which is just 1% of the entire mutual fund industry. In comparison, hedge funds control $2.7 trillion of capital.

The trend is picking up, particularly as conservative institutional investors like pension funds enjoy ’40 Act funds due to the lack of performance fees, reduced leverage, and beta-centric returns.

The alternative ’40 Act fund universe is in its infancy, with the most mature funds being no more than five years old. While industry watchers like McKinsey predict the industry will continue its exceptional growth, only time will tell if these vehicles can weather a storm.

Rather than debate the permanence of alternative funds, investors should instead ask a more important question:

Do increased liquidity and the lower fees provided by hedge-like mutual funds outweigh the lower expected returns?

optimism remains high 

The hedge fund versus alternative funds is a false debate thanks to industry advocates who are attempting to promote their products and services. They’ve said alternative funds don’t provide strong returns, aren’t managed properly, or that investor sentiment is dwindling. 

But there is no shortage of optimism surrounding the launch of alternative ’40 Act funds.

“Clearly, this is the fastest growing category,” said Victor Viner, president of V2 Capital, which specializes in volatility-based equity derivative strategies. V2 Capital manages $500 million in a hedge fund vehicle, but is rolling that money over into a ’40 Act fund later this year. 

“We are seeing more funds that can provide liquidity going into the liquid alternatives space for all of the obvious reasons from an investor perspective,” said Viner, adding that the main benefits of liquid alternatives include transparency, liquidity, and lower fees. But despite V2’s move into the liquid alternatives space, Viner warns that most hedge funds cannot be shoehorned into mutual fund structures.

“Not all, and not most, of traditional hedge fund strategies can exist in these structures. In our case, we’re lucky because everything we do and have done for four years falls well within the framework of what can be done in a ’40 Act fund,” said Viner. 

The ’40 Act rules include limiting leverage to 33%, having less than 15% exposure to illiquid assets, and in most cases a prohibition on charging performance fees.

Adam Patti, CEO of IndexIQ, a pioneer in the liquid alternatives space, agrees that only certain strategies will work in a ’40 Act structure. 

“The major hedge fund categories—long/short, market neutral, global macro— can [be] provided in a ‘40 Act fund fairly efficiently,” he said. “Strategies that require a significant amount of leverage won’t work. Strategies that tend to depend on illiquid, arcane asset classes won’t work.”

Instead of having a “one of the other philosophy” when comparing hedge funds and liquid alternatives, investors could see them as complementary products.

“The majority of our assets ($1.4 billion) are in a multi- advisory product that is basically the S&P 500 of the hedge fund market,” said Patti. “It is designed to give you the risk/return profile of a universe of a hedge fund of funds…. You would use that as a core product in your portfolio and then go out and find alpha-seeking hedge funds as satellites around it.”

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