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Understanding Liquid Alternatives: Ask The Right Questions

Financial advisors and other professional investors often have a lot of questions about liquid alternatives, and for good reason. The investment strategies used in alternative mutual funds and ETFs are not straight forward by any means. Many use some form of leverage. Most utilize the ability to short securities, while others use a variety of derivative instruments to efficiently gain exposure to certain assets classes or securities. But when used properly, liquid alternatives can be an effective tool to mitigate risk, increase diversification and/or enhance returns. So what questions should advisors be asking? To answer that question, Cognios Capital , managers of the Cognios Market Neutral Large Cap Fund (MUTF: COGIX ), has produced a handy guide, “FAQ: Liquid Alternatives.” The eight-page white paper answers the following frequently asked questions: What is the difference between traditional alternative investments and liquid alternatives? What is the benefit of adding alternatives to my portfolio? How many different alternative strategies do I need? From where should I fund my alternative allocation? Are there risks that are unique to alternatives? Why not just invest in a multi-strategy fund? Why is there such a large difference in returns among the different types of alternative strategies? What does it mean to be Beta Neutral? How are fees and expenses reported for alternative mutual funds? Cognios’s white paper answers each of the above queries in great detail, devoting nearly a page to each answer. What follows is an abbreviated summary of the report. Traditional vs. Liquid Alts Alternative investments include assets such as commodities, currencies, and private equity; as well as public-equity strategies such as long/short equity, market neutral, and equity arbitrage. Traditional alternatives are subject to less stringent regulation by the SEC, have less liquidity and transparency than liquid alts, and are open to wealthy individuals and institutions only. Liquid alts offer similar exposures but through SEC-regulated mutual funds and ETFs, with daily liquidity and greater transparency. Benefits of Allocating to Alts Alternatives present many potential benefits, but perhaps the most obvious is their potential to improve the risk-adjusted return of portfolios through exposure to assets and strategies with low correlation to traditional stocks and bonds. How Many Alts are Needed? According to Cognios, a 10% to 25% allocation “may be an optimal range” for individual investors. As for the optimal number of different alternative strategies, this depends on investors’ desired outcomes. Alternatives aren’t a single “asset class” – a variety of strategies pursue a variety of different outcomes. Funding an Alts Allocation Should alternatives be funded from the equity portion of a portfolio, the fixed-income sleeve, or a separate “alts” sleeve? According to Cognios, there is no one right time to add alts to a portfolio – and similarly, there is no one right way to fund them. Unique Risks Cognios cites the following as unique risks to investing in alts: Insufficient manager experience Limited track records Difficult-to-understand strategies Multi-Strategy Funds Investing in a multi-strategy fund leaves the decision of which strategies to invest in and how much to allocate to each strategy up to an outside manager. While this can be beneficial, multi-strategy funds sacrifice customization for ease. Furthermore, multi-strategy funds aren’t always fully diversified within the alts space, so certain single strategy funds may be needed to complement multi-strategy holdings. Dispersion of Returns Since alts aren’t a single “asset class,” it makes sense that there would be a wide dispersion of returns across the different alternative assets and strategies. But even within a given strategy, wide dispersion between the best and worst performers is common, since many funds operate different sub-strategies and most are unconstrained by benchmarks. Beta Neutrality A “beta” of 1.0 indicates 100% correlation with a given benchmark. Equity market neutral funds pursue “beta neutrality,” meaning a beta of as close to 0.0 as possible. This way, their returns are isolated from the fluctuations of the broad market. Liquid Alts Fees While alternative mutual funds certainly have lower fees than their hedge-fund counterparts (in most cases, at least), their fees aren’t necessarily as straightforward as those of traditional mutual funds. This is because strategies that engage in short-selling incur related costs, whereas traditional mutual funds don’t sell short, and thus don’t incur these added charges. Download the full guide for complete answers to the nine questions (linked above). Jason Seagraves contributed to this article.

4 Best-Rated Utility Mutual Funds For Stable Returns

Investors with a conservative mindset looking for stable current income would do well to consider utility funds. They are used as defensive instruments, which protect investments during a market downturn. This is because the demand for essential services such as those provided by utilities remains unchanged even during difficult times. In recent years, many funds in this category have increased their exposure to emerging markets and unregulated companies. Though this strategy has increased the risk involved, it has also generated higher returns. Below, we will share with you 4 top-rated utility mutual funds . Each has earned a Zacks Mutual Fund Rank #1 (Strong Buy) as we expect these mutual funds to outperform their peers in the future. AllianzGI Global Water Fund A (MUTF: AWTAX ) seeks long-term capital growth. AWTAX invests a major portion of its assets in common stocks of companies that are represented in the S&P Global Water Index, the NASDAQ OMX US Water or Global Water Indices or the S-Network Global Water Index, or are involved in water-related activities. AllianzGI Global Water A is a non-diversified fund and has a three-year annualized return of 3.6%. Andreas Fruschki is the fund manager since 2008. Kinetics Alternative Income Fund C (MUTF: KWICX ) invests a large portion of its assets in the Alternative Income Portfolio, a series of Kinetics Portfolios Trust that holds a portfolio of primarily fixed-income securities. KWICX seeks to provide current income. Kinetics Alternative Income Fund C is a non-diversified fund and has a three-year annualized return of 1.3%. As of September 2015, KWICX held 327 issues, with 11.58% of its total assets invested in the iShares 1-3 Year Credit Bond. American Century Utilities Fund Inv (MUTF: BULIX ) seeks current income and capital appreciation. BULIX invests a major portion of its assets in equities related to the utility industry. BULIX’s portfolio is based on qualitative and quantitative management techniques. In the quantitative process, stocks are ranked on their growth and valuation features. American Century Utilities Fund is a non-diversified fund and has a three-year annualized return of 9.9%. BULIX has an expense ratio of 0.67% as compared to the category average of 1.25%. Putnam Global Telecommunication Fund B (MUTF: PGBBX ) invests a large portion of its assets in both mid and large capitalization companies across the world. PGBBX generally invests in securities of companies that are part of the telecommunication industry. Putnam Global Telecommunication B is a non-diversified fund and has a three-year annualized return of 6.5%. Vivek Gandhi is the fund manager since 2008. Original post

Over-Rated: Do Fund Asset Classifications Tell The Whole Liquidity Story?

By Hamlin Lovell, CFA Suspensions of dealing by the credit mutual funds Third Avenue and Stone Lion have prompted various knee-jerk requests for a simple rule of thumb to help avoid recurrence: Beware Level 3 assets. It is reported that Third Avenue owned 18% in Level 3 assets. Many credit funds have zero or less than 1% of their assets in this category. Behavioral finance teaches us that we are susceptible to messages that simplify the complex. Unfortunately, financial market liquidity may not be amenable to such simple rules. Level 3 assets are assets for which a fair value can’t be determined by observable measures such as models or market prices. Though they are commonly dubbed mark-to-model, any unobservable input applied to modify a market price can also lead assets to be classified as Level 3 despite their valuation not being entirely model driven. Furthermore, relying on the Level 1/2/3 breakdown as a proxy for liquidity can result in both false positives and false negatives. Let’s start with the false negatives. Absent or insufficient market prices or dealer quotes can be reasons for Level 3 classifications, but they are not the only reasons. For instance, derivatives with non-standard maturities may be valued by interpolating between broker quotes on those derivatives with standard maturities. So a six-week currency option might be valued roughly halfway between a one-month and a two-month quote, but if the fund in question offers quarterly dealing, there need not be grounds for concern about asset/liability mismatches. But Level 3 is a broad range. At the other end of the spectrum, Level 3 could include private equity that might never be monetized, leading to an immortal “zombie” fund. Many assets might fall between these negative extremes; structured credit, for example, can be self-liquidating if cash flows from underlying assets accrue to various tranches according to the predetermined schedule. Some short-dated structured credit assets could generate cash flows faster than, say, zero coupon or payment-in-kind (PIK) bonds, where there may be indicative broker quotes – but you’d only find out if the borrower could repay (or refinance) at the maturity date! So using Level 3 categorizations to avoid illiquids is a crude tool. Of course, for those investors not worried about missing some adequately liquid assets falling under the Level 3 umbrella, a “Level 3 is bad” rule should still avoid many of the least liquid and completely illiquid assets. Less discussed and of greater concern are the false positives that can arise from assuming Level 1 and Level 2 must be liquid. That assets have an exchange price or some form of counterparty quote does not mean they can be traded in unlimited amounts, as the price or quote may only be good up to certain volume levels. Indeed, Third Avenue claimed it cannot liquidate “at rational prices,” which may imply they could sell at discounted prices. Any asset’s liquidity needs to be seen in the context of the fund’s position size, and I have seen funds take months or years to exit some Level 1 or Level 2 securities when they are holding a substantial multiple of volumes. The bottom line is that valuation methods should not be used to draw inferences about liquidity. Credit Ratings Third Avenue owned significant amounts of assets with a CCC credit rating, which may be deemed extremely speculative. The impulsive response here is to suggest that funds with higher credit ratings are more liquid, or less risky, or both, than those with lower (or no) credit ratings. Let us remind ourselves that some asset-backed security vehicles stamped AAA and backed by subprime mortgages ended up worthless and illiquid during and after the 2008 crisis, to the chagrin of institutional investors ranging from Norwegian pension funds to German municipal banks. Some money market funds that were perceived as super-safe cash substitutes also had to suspend dealing in 2008, and they were, broadly speaking, required by Rule 2a-7 to hold assets bearing the highest two short-term credit ratings. Since September 2015, money market funds are no longer bound by this constraint , as Dodd-Frank requires them to ensure assets meet a range of appropriate criteria. “Unrated” Assets When an asset is unrated, it generally means that the issuer has declined to pay for a credit rating rather than that the ratings agency has declined to provide one. The amount of C-rated issuance seen in the United States and Europe over the past two years shows that agencies are perfectly willing to provide some of the lowest credit ratings to companies that may be stressed or distressed. Convertible debt is often not rated, but this does not necessarily mean it is less liquid. I recall convertible bond funds largely comprising unrated names in 2008 paying out plenty of redemptions on time. In any case, credit ratings are not necessarily a reliable proxy for liquidity. Some credit assets reportedly see higher volumes after they get downgraded or default, partly because some holders become forced sellers and specialist distressed investors then become interested in the higher potential returns on offer. So, neither valuation hierarchies nor credit ratings can necessarily guarantee fund liquidity. Nor can regulation – both US mutual funds and US money market funds are now allowed to suspend dealing, and the SEC has approved Third Avenue’s suspension. Investors and advisers need to broaden and deepen their levels of analysis to get a better handle on liquidity risks. Quantifying fund liquidity is not only nuanced but also fluid, particularly as there can be seasonal variations, with calendar year-end reportedly a less liquid time. Investors and asset management companies may be drawn to the apparent certainty of putting funds into a small number of boxes, buckets, or categories, but this may prove to be a false comfort. Exact estimates of fund liquidity could prove to be spuriously precise, so the concept needs to be presented in broad brush terms that allow plenty of margin for error. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.