Mutual funds that mimic hedge fund strategies — the so-called liquid alternatives sector — were among the hottest investments just a few years ago. Despite lagging returns and setbacks at several noteworthy funds, retail investors until recently have stuck with them even as they have pulled billions of dollars out of other funds.
There may be early warning signs that that is about to change.
The current market leader is a trend-following financial futures fund called the AQR Managed Futures Strategy Fund, which has ridden the downturn in oil prices and interest rates to a recent peak of $14.3 billion (Dh52.5 billion) of assets.
Its sponsor, Clifford Asness’ quantitative investment firm AQR Capital Management in Greenwich, Connecticut, has become the biggest manager of liquid alts, with $25.7 billion in nine different funds. But like others in the sector, AQR has not been able to shake off lacklustre performance. Returns for its managed futures fund of just 2 per cent in 2015 and negative 1.8 per cent in 2016 have fallen short of its average annual return of 9.5 per cent in 2013 and 2014.
AQR says the fund, which also holds stock and currency futures, acts as a diversifying “shock absorber,” offering protection during market declines.
The once-torrid growth of liquid alts, which quadrupled to $180 billion of investor assets from 2008 to mid-2014, petered out over the last two years. Assets remain steady at a current $175 billion, according to Morningstar, a research firm in Chicago that tracks mutual funds. That is remarkable considering the large outflows from the sector’s former juggernaut, the Marketfield Fund, which shrank from a 2014 peak of $21.5 billion to a current $1 billion partly because of ill-timed bets on commodities and China stocks.
Active mutual funds
In the last five months, however, investors have pulled $5.1 billion from liquid alts. They still have not fled to the same degree they have abandoned active mutual funds generally. In the two years ended in June, $410.5 billion had been pulled from active managers, or 4.2 per cent of average assets for the period, as their performance often trailed the market. In their place, investors have stampeded into lower-fee “passive” index funds, which aim to match returns for major stock and bond indexes.
Jason Kephart, an alternative investments analyst at Morningstar, said interest in liquid alts had plateaued because, “painting with a broad brush, performance has really been underwhelming, and the fees are probably still too high.”
Doug Black, founder of Aronson SpringReef, which reviews the performance of financial advisers, said in the last two years investors had poured $25 billion into managed futures and multi-alternative strategies, essentially funds of hedge funds.
That interest may be largely because brokers and financial advisers have been selling liquid-alt funds to investors as an alternative to risky and richly priced stocks and bonds, Black said. “Nobody is calling their broker and saying ‘I would like a multi-alternatives fund or a managed futures fund.’”
The funds are more expensive than plain vanilla mutual funds; fees for liquid-alt funds average more than 1.3 per cent annually, compared with 0.77 for all active managers, according to Morningstar.
Restrictions
The liquid-alts sector took off after the financial crisis of 2008, when investors intensified their search for funds that could protect them from the full force of a severe stock market decline. Hedge funds are limited to investors who have enough net worth or income to weather an investment loss and who agree to restrictions on taking their money out of the funds. Liquid-alt funds were created to copy the strategies that popular hedge funds followed, but in a mutual fund structure that made investing in them available to the mass market and easily redeemable.
But early standout funds like Marketfield fell into a familiar pattern. They initially posted a few years of outsize returns that drew investor dollars and fat fees for their sponsors and followed that with disappointing returns that prompted investors to flee.
Joel Greenblatt of Gotham Asset Management claimed in his 2005 book “The Little Book That Beats the Market” to have a “magic formula” that beat the market — on paper — by an average 10 percentage points annually from 1988-2004.
Beginning in August 2012, Gotham rolled out nine funds using methodology similar in some respects to the magic formula. While they used similar valuation yardsticks, they picked far more stocks than the 30 chosen using the magic formula. They also bet on a price decline by selling stocks short.
Market exposure
With varying degrees of market exposure and above-average fees of 2 per cent annually, the Gotham funds pulled in $6.5 billion by February 2015.
The Gotham Absolute Return fund beat the market in its first four months, even though it had a net market exposure of only 60 per cent — meaning it bought stocks worth 120 per cent of its assets and sold short stocks worth 60 per cent of assets. It pulled in $3.7 billion at its peak.
But in 2015, the fund faltered, losing 10.2 per cent while the Standard & Poor’s 500 index gained 1.4 per cent. It also trails its target market exposure this year. As a result, investors have withdrawn their money, shrinking the fund to just $1 billion. Gotham’s total mutual fund assets have shrunk by more than half to $2.9 billion.
Gotham Enhanced Return fund, which Morningstar considers a conventional fund, has a 100 per cent market exposure of 170 per cent long and 70 per cent short. It, too, beat the market in its first two years, 2013 and 2014, attracting $1.6 billion of investor assets. But it trailed the market by more than 12 percentage points in 2015 and its assets have since fallen below $1 billion. As of now, it has trailed the market for the fund’s entire three-year life — something Greenblatt’s book said had only a 5 per cent or less chance of happening with the magic formula.
Gotham’s own reports have blamed the results on the short portfolios, without elaborating. They also noted that the funds compared more favourably with an index of hedge funds, which have also faltered lately. Greenblatt declined to comment.
Some liquid-alts officials acknowledge the pattern. “It’s a challenge for all of us to overcome the boom-bust, hero-goat profile,” said David Jilek, chief investment strategist at Gateway Investment Advisers, manager of the Gateway Fund, the second-largest liquid-alts fund at $8.2 billion.
Pulling client assets
The track record of the third-largest liquid-alts fund, the $8.1 billion John Hancock Global Absolute Return Strategies Fund, has also lagged, with average annual returns in its first three years 2012-14 of 5.6 per cent falling to just 1.7 per cent in 2015 and negative 4.8 per cent so far this year. It, too, has had recent outflows.
Fidelity Investments pulled client assets in March from a multimanager fund run by the Blackstone Group as value dropped 6.6 per cent in three months. Fidelity officials declined to comment.
Fidelity seeded the fund with $1 billion in 2013 and had a one-year exclusive on it. Fidelity still uses liquid alts to diversify 3 to 4 per cent of assets for some wealthy advisory clients.
Blackstone started a similar fund of its own in mid-2014, tracking the strategies of 19 hedge fund managers including D.E. Shaw and Cerberus. Although the $4.7 billion fund also suffered a 5.6 per cent drop in value last winter before rebounding, it kept pulling in new money in the second quarter, but had outflows in recent months.
Liquid-alts managers remain optimistic. David Kabiller, co-founder of AQR, said his firm aimed to offer alternatives to individuals through financial advisers that can diversify returns on stock and bond portfolios, much as they do for pensions and university endowments.
