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Have Liquid Alternative Funds Gotten Any Better?

A client recently asked me why Artemis doesn’t invest in so-called “liquid alts” and I replied that when I looked at them some time ago, I wasn’t impressed with their performance or their fees.  But my analysis is at least 10 years old so I recently decided to have another look.

What are liquid alternative funds? They are mutual funds that attempt to replicate various strategies that hedge funds deploy such as long/short equity and event-driven. But because they come in a mutual fund wrapper, they are fully liquid and open to all investors, not just accredited (a.k.a. high-net-worth) investors.

The attraction to liquid alternative funds is often because they can invest in assets such as commodities, futures, leveraged loans, start-up companies and unlisted securities—all of which offer exposure beyond traditional stocks, bonds, and cash. The strategies liquid alts employ also tend to fall on the more sophisticated, elaborate, or complex end of the spectrum. Examples include hedging and leveraging through derivatives, so-called “long-short” strategies and short selling, and “opportunistic” strategies that change with market conditions as various opportunities present themselves.  In short, the idea is that having some of them in one’s portfolio may enhance diversification and/or boost performance.

Conveniently, some researchers at the investment research firm Morningstar recently did my research for me.  Specifically, they examined the performance, volatility and fees associated with U.S. liquid alternative funds across nine different strategies.  As shown in the figure below, the results are underwhelming with all strategies resembling bond funds in terms of their risk and return characteristics but come with very high fees. To show this point, I pulled the same data on three large Vanguard bond funds we use a lot here at Artemis and they all show returns and volatility stats that are very similar to the liquid alternatives, except that they are a whole lot cheaper.

 

Figure 1.  Liquid Alternative Fund Statistics

Liquid Alts Chart 1

*Tax-equivalent yield (35% assumed tax rate); Vanguard funds: VFIDX, VWIUX and VMLTX

Source:  Morningstar, January 2024

 

But what about a diversification benefit? To address this question, the Morningstar team looked at the correlation between the average alternative fund and the S&P 500 and found a correlation coefficient of .70 (1 is perfect correlation). By way of comparison, all three of the bond funds from Vanguard sport a very low and even negative correlation with the S&P 500, depending on the time frame.

Finally, the Morningstar team also points out that more than 50% of the liquid alt funds they examined come with either an upfront or redemption fee above 1% that is not reflected in the returns shown in the chart.

Bottom line:  Liquid alts are just as underwhelming today as they were 10 years ago when I first looked at them.

Picture of Leigh Bivings, Ph.D., CFP®, CDFA™
Leigh Bivings, Ph.D., CFP®, CDFA™
Leigh is CEO and Founder of Artemis Financial Advisors LLC. Leigh has a Ph.D. in applied economics from Stanford University and is a Certified Financial Planner (CFP®) and Certified Divorce Financial Analyst (CDFA®). She enjoys working with clients and strives to give them peace of mind and robust frameworks so that they can make more informed choices about spending and saving and make these choices with enhanced confidence.

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