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Hedge funds may make sense for some investors, especially when the opportunities are unique and the allocation is small. Because of their typically high fee structure, lack of transparency, illiquidity, capacity limits, and challenging due diligence process, hedge funds may not be the best choice for institutional investors. That accounts for the growing popularity of liquid alternative investments (LAIs), systematic investment strategies that employ similar return sources as traditional hedge funds. By Wei Ge, Senior Researcher Hedge funds may make sense for some investors, especially when the opportunities are unique and the allocation is small. Hedge funds also offer great potential alpha opportunities for accredited investors or investors with access to information, opportunities, and investment acumen who can extract favorable fee terms from hedge fund managers. Hedge funds are historically organized as limited partnerships, limited liability companies, or similar vehicles that are sold through private channels, allow only a limited number of accredited investors, and typically have minimum investment thresholds in the millions of dollars. Because of their typically high fee structure, lack of transparency, illiquidity, capacity limits, and challenging due diligence process, hedge funds may not be the best choice to be used en masse by the majority of institutional investors. As our understanding of investment returns grows, however, hedge fund returns that were traditionally attributed as manager alpha can now be explained by exposure to alternative beta, and it is increasingly common for analyses of hedge fund returns to be divided into: traditional beta, alternative beta, and finally, “true manager alpha.” True manager alpha is usually elusive, temporary, limited in capacity, expensive, and hard to capture for most investors. In response to these challenges, liquid alternative investments (LAIs) have been growing in popularity and variety. LAIs are systematic investment strategies that employ similar return sources as traditional hedge funds, including: managed futures, event driven trading, carry, liquidity, momentum, value and volatility selling, and others. Because many LAI funds are designed to help investors capture the unique risk-return characteristics of hedge funds, it is not surprising then that such investments are experiencing rapid growth with an increasing array of choices being offered. Today, LAIs come in the form of separate account portfolios, mutual funds, closed-end funds, or ETFs. LAIs have some limitations, too, many of which caused by their shorter and less familiar histories in the market. Because the underlying investments of LAIs need to remain liquid and scalable, they cannot take advantage of the same limited, illiquid, transitory, or more elusive opportunities exploited by hedge funds. Similarly, LAIs cannot replicate many of the highly leveraged strategies used by hedge funds. Nonetheless, investors who are dissatisfied with hedge funds may find LAIs more attractive in terms of reasonable cost, greater transparency, liquidity, a more user-friendly format, and simpler due diligence. Lower Fees – LAI funds usually charge a flat fee, which is much lower than the sliding fee structure of hedge funds. Lower fees leaves a greater share of the return in the investor account, and can represent a significant saving over time compared to hedge fund fees. Higher Transparency – In contrast to hedge funds that have undisclosed strategies and often focus shifts in search of investment opportunities, LAIs typically attempt to monetize on defined strategies and risk premiums, and is fully transparent with its investment objective. A clearly defined investment focus may help investors to construct a portfolio that includes different potential sources of return. Improved Liquidity – LAIs can also be much more liquid than hedge funds, many of which have limits on withdrawals or redemptions. Since LAIs predominantly invest in exchange-traded instruments, they are by design easier to liquidate than hedge fund investments, and can provide reliable daily pricing information. Easier Accessibility – There are several features that make it potentially easier for investors to use LAIs. Because of no limits on the timing or size of withdrawals, and less stringent limits on the number of investors, LAIs may provide more investors access to the alternative asset class. The straight forward construction of LAIs may also create a more even playing field by providing liquid and standardized formats, with a large enough capacity to be available to more investors. Within a diversified portfolio, investors may utilize the core-satellite framework to make asset allocation decisions for the alternative asset segment. They can invest a large portion of the alternative allocation to a core set of LAI funds, utilizing different investment styles, risk exposures, and hedge fund betas as return sources, with generally lower costs and the benefit of transparency and liquidity. The rest of the alternative assets may be invested in high-conviction traditional hedge funds (satellites) that may supply true after-cost alpha and give investors a chance to enhance returns. The core-satellite framework is flexible and comprehensive, easily adjusted to suit the needs of different investors under a wide range of circumstances, especially with the complex decisions regarding liquid alternative investments versus hedge funds. Scalper1 News
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