Although many investors were burned during the GFC by the liquidity shortfalls of alternative investments, retail investors now have better opportunities to build up portfolios that offer reliable liquid alternative strategies and assets both locally and globally, writes Dominic McCormick.
One of the big criticisms of many alternative investments, particularly for retail investors, is their poor or uncertain liquidity.
This was highlighted in the GFC for small and large investors alike as a range of alternatives funds failed, suspended redemptions, or were difficult to exit at other than significant discounts to net asset value.
As a result, some retail investors remain cautious about alternative investments, demanding greater and more reliable liquidity. Fortunately, the scope for retail investors to access and build portfolios of reliably liquid alternative strategies and assets continues to improve locally as well as globally.
It seems local retail investors have developed two broadly divergent preferences regarding liquidity on investment products across their portfolios in the wake of the GFC. On the one hand they desire that the bulk of their investments provide very high liquidity – ideally daily, or perhaps weekly.
On the other hand, the only highly illiquid investments they will accept are those in asset classes they know well, typically with a defined future date for repayment or a liquidity event (eg, property syndicates).
Direct ownership of residential and commercial property is another low-liquidity asset that appeals. Investments that don’t easily fit into these two broad categories from a liquidity perspective are generally being shunned by Australian retail investors.
The good news is that the ability of retail investors to access liquid alternative investments has improved in recent years and this is allowing portfolios to contain a meaningful allocation to a range of alternative investments, while remaining highly liquid.
This is occurring at a time when alternative investment allocations of up to 30 per cent are being recommended by some asset consultants and research houses.
Of course, these liquidity-focused investors are not able to access the extensive universe of alternative asset and strategy opportunities that long-term institutional pools of capital such as large super or endowment funds can, but nevertheless the choice is clearly expanding.
Global demand increases
In a recent ‘Rise of Liquid Alternatives Survey’, Citi sees global demand for liquid alternatives from the retail audience reaching US$939 billion by 2017, and US$1.3 trillion including institutions seeking greater liquidity.
They note that this would make the liquid alternatives market nearly as big as the entire hedge fund industry at the end of 2008.
Such growth should be welcomed by investors. Indeed there has been a risk that the quest for liquid options in recent years, while there have been limited offerings, has left many investors with an excessive focus on managed futures only.
Unfortunately, the last couple of years have been a tough period for most managers in this strategy, with negative returns as a whole for 2013 so far.
Despite this recent performance, managed futures have clearly become well accepted by retail investors in recent years as major groups like Winton, Aspect and AHL have entered the market.
Long/short equity is increasingly a strategy offered by mainstream and alternative managers, with more frequent liquidity than the monthly or quarterly liquidity offered by standard hedge funds.
There are also a small number of highly liquid global macro/TAA funds and commodity-related funds. Other “quasi-alternative” categories like listed infrastructure funds have also proliferated in recent years.
Another driver has been the growth of hedge fund replication products which attempt to provide the risk-return profile of certain hedge fund strategies by using more conventional asset classes.
I have some scepticism that these products can provide the true diversification and return benefits investors are looking for.
Part of this trend to greater liquidity is being driven by the response of hedge funds and fund of hedge funds to the GFC.
Hedge funds rethink approach
Hedge fund of funds groups in particular have been forced to totally re-work their offer, especially if they are intending to appeal to retail investors.
Many have built managed account structures to access individual hedge funds that allow greater liquidity, transparency and lower cost.
The growth of hedge fund beta products that offer lower cost and more liquid access to hedge fund diversification benefits has also expanded the universe and accentuated pressure to improve retail offerings.
Another driver to greater liquidity of alternatives has been the growing demand and desire of fund managers to offer alternatives into the US Mutual Fund Market and the European UCITS structure.
These structures require much greater liquidity as well as having restrictions on leverage and compensation arrangements.
However these restrictions have not stopped a range of hedge fund managers and traditional managers with hedge fund products moulding their offerings to fit into the requirements of the US Investment Company Act.
Managed futures, long short and market neutral equity, merger and event arbitrage as well as more diversified fund offerings such as hedge fund beta and selected fund of funds are being incorporated into such structures.
Exchange traded funds (ETFs) are also growing as a way to offer some alternatives, despite the even greater restrictions that this structure offers. For example, precious metal and commodity ETFs have grown rapidly in global markets in recent years.
All of these developments have also resulted in lower fees to investors on alternative investments, one of the biggest, and generally valid, criticisms of many alternative investments.
Listed investment companies
Another small but often neglected area of liquid alternatives is listed closed end funds or listed investment companies (LICs), as they are generally known in Australia.
The advantage of this structure is that it can actually provide daily liquidity to those alternatives strategies that are inherently illiquid. Most prominent of these is private equity and debt, although some less liquid hedge fund strategies and specialist areas like agriculture and timber have also been offered in this structure.
Recently a market neutral Australian equity LIC raised over $70 million.
Of course this structure comes with some limitations – quite limited vehicle/manager choice, still high fees, occasionally poor governance and the tendency to trade up and down with the market, irrespective of the underlying strategy which can dilute diversification benefits.
Related to this is the tendency of these vehicles to trade at a discount or premium to Net Tangible Assets (NTA) – although approached with discipline this can provide opportunities.
If investors can be selective regarding manager quality – and only buy LICs when they are trading at discounts to realistic NTA and where there are catalysts for that discount to narrow – then these vehicles can provide very attractive returns.
Such listed fund investments can be seen as a valuable satellite or complement to a broader liquid alternatives portfolio.
An expanding universe
The liquid alternatives universe is clearly growing and enabling the construction of increasingly robust alternative portfolios for retail investors, something that would have been difficult to achieve even just a few years ago.
Of course, having a greater array of liquid alternatives to choose from does not necessarily make selecting them or building a portfolio is an easy task, given the complexity of many alternative assets and strategies.
Further, there are many high quality alternatives managers and strategies that are difficult for retail investors to access for reasons other than liquidity, such as those without an Australian presence or those that operate only through offshore funds.
This highlights the role that professionally managed, pooled multi-manager alternative vehicles – even if focused on mostly liquid funds – can provide.
Recent greater volatility in mainstream equity and fixed interest markets after a strong run from mid-2012 – and the limited long-term value on offer – is increasing the need for robust alternative exposures that offer true diversification.
Fortunately, there is an increasing array of alternatives becoming available to retail investors without the illiquidity risk that can often discourage them.
Investors should therefore welcome the greater availability of liquid alternatives, particularly in a world where expected returns over coming years on a range of mainstream assets classes are subdued, and the risk-reducing and diversification benefits of a well selected range of alternative investments are increasingly valued.
Dominic McCormick is the chief investment officer at Select Asset Management.
