Five reasons to be cautious in a fast-growing asset class
Liquid open-ended alternative funds are hedge fund-like strategies that are adapted for a broader investment audience. This asset type has seen massive expansion in recent years. Since the 2008 global financial crisis, they have been among the main growth areas in the European and UK fund industries, increasing their total assets under management by 25 per cent per year.
But what has drawn investors to this asset class? Morningstar recently published the Cross-Border Liquid Alternative Fund Landscape Report 2019, a paper analysing the growth of the liquid alternative industry, and we conclude that much of the hype surrounding the asset class was built on expectations and promises, rather than results.
True, there are good arguments in favour of their inclusion in a diversified portfolio. As central bank measures have hammered interest rates down to record low levels, investors have been forced to look beyond traditional assets for returns that would have less risk than equities.
Apart from the investment considerations, the growth of the liquid alternative industry has been driven by supply-side factors.
Where many asset managers are seeing their equity and even fixed-income funds challenged by the rise of cheap index funds, the alternative space is still almost an “active kingdom”, which provides breathing space to the asset managers’ bottom line.
Despite the massive growth of the sector, the universe is far from mature, and we think investors should exercise caution when investing in liquid alternative funds for these five reasons:
1. Turnover in fund line-ups
According to our calculations, around 3,200 alternative funds were launched over the past decade. On average, 324 new funds have been launched each year since 2009. In the 2009/18 decade many funds died as well. A fund dies when it is either merged into another fund, or its assets are liquidated and distributed to existing shareholders. This means that long-term investors must consider carefully which funds may live long enough to provide them with good long-term returns.
2. Leadership shifts
We took a snapshot of the top 10 funds at three different year-ends: 2009, 2013 and 2018. The table below shows how temporary and feeble victory can be in this universe. The message is that many past winners turned out to be lousy investment propositions in later years. For instance, JPM Highbridge Statistical Market Neutral, one of the top 10 European alternatives back in 2009, does not exist today. One of the largest players on the 2013 list, GAM Multibond Absolute Return Bond, was liquidated in 2018 after its lead manager was suspended in the wake of an internal investigation.
3. A dearth of time-tested strategies
The expansion of the asset class brought into the market a lot of new players. Today, the European liquid alternative space counts more than 2,000 options with seemingly endless variations of different types of strategies.
The main issue for fund selectors looking for viable long-term investments is, in fact, not having too many options. Only few funds pass a modestly strict set of criteria. Our data shows that only around 5 per cent of the alternative funds have been about for over five years, comply with the Ucits regulation, have at least €100m (£86m) in assets under management, and did not lose money in the three-year period through to the end of 2018.
4. Most liquid alternatives did not protect investors from the 2018 carnage
Most liquid alternative funds are not just young: they have not been stress-tested through a prolonged bear market. As a result, 2018 proved an interesting test as to whether these funds could deliver on their promise to provide returns irrespective of the performance of traditional asset classes.
The key conclusion is that most alternative funds flunked their first big test in 2018. True, the year was very difficult as the large majority of markets suffered losses. But still, in 2018, 83 per cent of alternative funds suffered losses.
5. The price is not right
If you wonder why European liquid alternative funds’ returns have been disappointing, look no further than costs. Fees remain the main factor hampering the appeal of liquid alternatives, as they directly eat into investors’ performance to dramatic levels as a percentage of net returns. The asset-weighted average ongoing charge of liquid alternative funds in Morningstar’s database is 1.08 per cent with all share classes included.
In addition, while performance fees are nowadays the exception for equity, fixed-income, or multi-asset products, around half of liquid alternative funds apply a performance fee, most typically 20 per cent, which adds to the fee load considerably in some years.
Matias Möttölä is associate director, multi-asset and alternatives at Morningstar, and Francesco Paganelli is analyst, manager research at Morningstar