The popularity of liquid alternatives strategies blossomed in recent years, and with it, the number of investment vehicles claiming to be part of the asset class. But not all liquid alternatives are true hedge fund proxies, and misconceptions exist about strategy classification. Modern Trader caught up with Nadia Papagiannis, Director of Alternative Investment Strategy at Goldman Sachs Asset Management, to explain.
Modern Trader: Tell us a bit about GSAM’s involvement in liquid alternatives, and why investors need to have a better understanding of what they are.
Nadia Papagiannis: We have a rich history of managing alternative strategies, and today we are one of the largest alternatives managers in the world. We also have a sizeable traditional mutual fund business. So it’s no surprise, then, that we were one of the first entrants into the liquid alternatives space in 2008, with our absolute return tracker strategy. We launched a multi-manager alternative strategy in 2013, and we now offer a range of liquid alternative strategies globally.
We have made a big investment in liquid alternatives because we really believe in it. We believe that investors need ways to achieve their financial goals other than stocks and bonds, especially in today’s environment of increased volatility, low interest rates and lower expected growth. While institutions and high-net-worth investors have been able to access alternative investments to help achieve their investment objectives, retail clients haven’t had the same opportunities until more recently.
MT: In your latest Market Analysis and Performance Summary (MAPS) report, you categorize the liquid alt space into five peer group segments. Why?
NP: The liquid alternative investment (LAI) peer groups covered in the MAPS serve two important purposes: One is to aid portfolio construction. To arrive at a strategic, diversified alternatives allocation, an advisor might select a couple of managers from each of the four single strategy LAI peer groups, or pick one or two managers from the multi-strategy peer group, which contains funds that are already more diversified. The second purpose of the LAI peer groups is better benchmarking. Funds in the same peer group should show similarities to each other and to their benchmarks. Hedge fund benchmarks have histories going back to 1990, through many different types of market environments. Because alternative mutual funds’ strategies generally aim to mimic those used in hedge funds, it makes sense to group [similar strategies together].
MT: The MAPS report suggests liquid alts, as segmented, performed as good as or better than, their hedge fund peers. If the strategies are similar, why would this be the case?
NP: Our MAPS analysis highlights that, in 2015, liquid alternative funds performed comparably to their hedge fund counterparts in every LAI peer group. Over longer periods of time, however, we have seen certain liquid alternative peer groups perform similarly to or better than hedge funds, while others have underperformed relative to hedge funds. The difference between the returns of liquid alternative funds and hedge funds with similar strategies can be caused by any one of a number of factors, including differences in fees, the liquidity of underlying investments and the use of leverage.
MT: As with hedge funds, performance dispersion among liquid alts last year was fairly wide. Did the lower cost and added liquidity of public instruments play a role?
NP: Alternatives generally demonstrate wider performance dispersion, or range of returns, relative to traditional asset classes. Last year, in particular, we saw exceptionally wide dispersion in hedge funds and alternative mutual funds as the result of higher volatility in virtually all risk (non-Treasury) asset classes, especially in the third and fourth quarters. Because alternative strategies are more actively managed and don’t track traditional market indices, increased volatility can lead to more long and short opportunities for alternative managers. Some get it right, and some don’t. That’s why it’s particularly important to diversify across alternative managers.
MT: A common criticism, especially among hedge fund managers, is that liquid alts take highly complex, levered, illiquid strategies and wrap them into simplified, ostensibly liquid wrappers, leaving investors with false impressions of what will happen when things go sideways. Thoughts?
NP: This is a common misconception. While many alternative mutual funds offer investors hedge-fund like strategies, they are not private placement hedge funds in a mutual fund wrapper. There are certain illiquid strategies offered as privately-placed hedge funds that cannot be offered as mutual funds, precisely because the underlying assets are too levered or too illiquid. Alternative mutual funds principally trade in liquid securities and instruments and cannot use as much leverage as a traditional hedge fund, due to regulatory constraints. In our MAPS analysis, we demonstrate that equity long/short, managed futures and global macro (collectively, tactical trading/macro), and multi-strategy have translated particularly well.
Other strategies, which in their hedge fund form utilize less-liquid instruments or higher leverage, are either not suitable to be managed in a daily liquid mutual fund format, or they need to be significantly adjusted to meet mutual fund requirements. We believe that this is why, in our MAPS analysis, we see event-driven and relative-value alternative mutual funds underperform their hedge fund counterparts over longer periods of time. That said, it is also possible that the underperformance in these two LAI peer groups could also be driven by a dearth of good managers in the space; they are by far the smallest categories.
MT: What about fund of funds, which have waned in popularity but are arguably well-suited to liquid alt formation? Do you think this particular type of hedge fund style will become more prevalent among liquid alt strategies?
NP: Multi-manager alternative mutual funds are effectively the liquid alternative equivalent to funds of hedge funds. They attempt to provide investors with manager selection, portfolio construction, and risk management in a turn-key solution. We believe these are great options for many investors as they provide diversified liquid alternatives exposure. Additionally, there are single-manager multi-strategy alternative mutual funds that attempt to provide hedge fund “asset class” exposure at a lower cost. Because many advisors don’t have the resources or expertise to allocate to a diversified group of individual alternative mutual funds, and because diversification is particularly important with alternatives, which have experienced wide performance dispersion, we think multi-strategy and multi-manager funds, specifically, will always be a large percentage of the alternative mutual fund assets.
MT: The last year has seen some deceleration in liquid alt growth, partly due to the market volatility but also arguably due to a saturated market. How do you see the industry developing over medium term?
NP: Last year did see a deceleration in liquid alternative growth. But importantly, it saw [greater growth vs.] traditional mutual fund asset classes, [which] saw significant outflows. We expect this slow, positive growth trajectory to continue with alternatives. Instead of “saturation,” I would call it “maturation.” We believe advisors are learning that they need to take a thoughtful, educated approach to investing in liquid alternatives.
MT: Unlike the institutional investor world, individual investors care more about absolute performance than relative performance. Where is the line between the “he who loses least wins the most” approach of relative hedge fund performance and the need for liquid alternatives to generate absolute returns?
NP: It’s true, investors want to see their investments grow, and may be less receptive to the risk management arguments for investing in alternatives. That’s why it’s important to educate and encourage liquid alternative investors to focus on the same diversification concepts on which institutional investors rely.
The goal of alternatives, as with other risk assets, is to generate positive returns over time, but not all assets are going to generate positive returns at the same time. That is why we recommend diversification, so hopefully something is working at any point in time. For the same reason investors diversify stocks with bonds, we suggest diversifying stocks and bonds with alternatives.
MT: Will liquid alts become as ubiquitous as ETFs? Are there downsides to such a development?
NP: Yes, we believe that over the next several years as advisors and investors become more comfortable with liquid alternatives, and as the quality of offerings continues to expand, we will not be talking about liquid alternatives as a new concept, but as part of a core allocation. I don’t see any significant downside to this evolution. There is a reason why institutions and high net worth investors have allocated to alternative investments for decades. Historically, they’ve worked.
MT: Is the liquid alt space developing differently in Europe with the advent of the UCITS structures, passporting, etc.? What are the advantages to this approach?
NP: The European market is quite different from the U.S. market, and can vary from jurisdiction to jurisdiction. Investors in some countries or regions seem to be reticent to move beyond traditional fixed income strategies, whereas others are more open to less-traditional investments, and have been allocating to liquid alternatives for longer than U.S. investors.