A Better Alternative?

By Tim Parker

The fastest growing category of mutual funds in the U.S. is a group of products called Liquid Alternatives, or Alternative Mutual Funds, which have generated increased scrutiny by securities regulators and the Investment Advisor community.[1] The amount of money in these products has exploded from less than $100 billion in 2007 to more than $800 billion in 2015.[2] These “Liquid Alts,” as they’re known, were created to give investors access to exotic strategies (hedge funds and non-traded REITS, for example) while still maintaining the daily liquidity and transparency typically associated with traditional, plain-vanilla mutual funds. While the alternative investment space has notoriously been plagued by obscure and problematically illiquid products in the past, Liquid Alts seek to offer the ‘best of both words’ by placing alternative instruments in a 1940-Act mutual fund wrapper. By doing so, they provide retail investors with access to tools and strategies historically available only to the accredited investor, which increases their appeal. Additionally, these Liquid Alternatives are seen as a form of diversification—the performance of hedge fund and real estate strategies is often uncorrelated (or inversely correlated!) to the performance of traditional stocks and bonds.[3]

But the use of Liquid Alts demand special awareness as you assess your liability as an Investment Advisor. Firstly, the data suggests that alternative funds experience larger volatility in investor redemptions, with the average variation in flows more than double that of the broader industry.[1] This can lead to disaster if market volatility causes a fund to suffer “net redemptions” and render it unable to return funds to investors.

However, the salient issue with these popular products is more nuanced, and strikes to a problem universal to all alternative investments. Alternative investments such as options and illiquid REITS often prove to be dramatically problematic not because of some inherent defect, but because of their complexity from a liability perspective. The true issue with your average alternative investment is in its difficulty to be explained. Why?

Let’s say a disgruntled client serves you with a Breach of Fiduciary Duty claim that arises from your use of an alternative investment. On the stand, you are called to explain to a panel of laymen why you selected and implemented this investment vehicle. In order to defend yourself, you begin to articulate the merits of this investment vehicle that led to its selection in the first place. Then it occurs to you: most of the laymen that you’re addressing, by no fault of their own, would most likely have trouble defining your run-of-the-mill 1940 Act mutual fund. They are not industry professionals with your level of financial savviness. Your case has become materially harder to make.

Alternative investments, because of their complexity and opacity, open up an avenue of risk that can be exploited by clients looking to stake a claim against an investment adviser’s livelihood. The use of a 1940-Act mutual fund wrapper to provide a higher level of liquidity and access, while certainly a step in the right direction, does little to mitigate these risks.

 

[1] http://www.chicagotribune.com/news/sns-wp-blm-sec-funds-c2187980-66ce-11e5-bdb6-6861f4521205-20150929-story.html
[2] http://wealthmanagement.com/mutual-funds/there-liquidity-risk-liquid-alts
[3] http://dailyalts.com/hatteras-explains-liquid-alts-help-build-durable-portfolios/

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