Key Takeaways
- Liquid alternatives are investing strategies that used to be available only through hedge funds, and these investments can provide diversification.
- A bucket between 5% and 15% of an investor’s portfolio seems reasonable for a liquid alts allocation.
- Morningstar has several different investment categories for liquid alts funds, split into two large buckets: portfolio diversifiers and opportunistic.
- The diversifier categories are those that don’t have any market exposure, such as equity market-neutral, which is going to balance its long and short exposure so that the only return should be the difference between the long stocks and the short stocks.
- Within the opportunistic bucket is the systematic trend category. These are trend-following strategies; when a market’s going up, it will be long, and when it’s going down, it will be short. With trend-following, they’re looking at moving averages.
- Systematic trend was the real liquid alts standout in 2022, but from 2013 through 2020, it had a lot of down periods. It is one of those insurance-type products that if you hold on to it, it does tend to work over the long term. But it can be painful to hold.
- Liquid alts’ fees tend to come at a significant premium to traditional investments. You may be paying more than 1% in management fees, but if you’re keeping the allocation small, it might not make a big impact on your returns.
Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Liquid alternatives funds provide individual investors with access to unconventional investment strategies. These strategies can enhance returns, protect against downside risk, and provide diversification benefits. So, what are the different types of liquid alts funds? What are their pros and cons? And what do you need to know about them before investing? Joining me to share some of the key questions to ask your advisor about investing in liquid alts funds is Jason Kephart. Jason is Morningstar’s director of multi-asset ratings. Good to see you today, Jason.
Jason Kephart: Thanks for having me, Susan.
What Are Liquid Alternatives?
Dziubinski: All right, let’s start at the beginning in very broad strokes. What are liquid alternatives? What type of investments fall into that big, broad bucket?
Kephart: In general, it’s basically investing strategies that used to be only available through hedge funds. Then after the financial crisis, there was a big demand from investors for more access to these diversifying strategies. And that’s when liquid alts really started to get popular after the 2010s. And now you’ve had a little over a decade of seeing how they act and if they live up to the hype.
Benefits of Liquid Alts
Dziubinski: Why might an advisor suggest that a client invest in liquid alts? What benefits do they provide?
Kephart: I think what you’re hoping to get out of a liquid alternative is some diversification. We know about stock risk. We know about bond risk, especially today where you have stocks trading at pretty rich valuations relative to their history. You have a lot of uncertainty over the path of interest rates. So, you may not be super comfortable with where your stock and bond portfolio is right now. The idea behind using a liquid alternative is to add something different that maybe won’t respond as directly to stock market moves or interest-rate moves. And that is the diversification benefit that I think people should be looking for when they look for liquid alternatives.
How Much of an Investor’s Portfolio Should Be Liquid Alts?
Dziubinski: How much of an investor’s portfolio would typically be dedicated to liquid alts?
Kephart: I think you want to have enough that it’s going to matter, right? So, 1% or 2% is probably not going to move the needle. We see anything from 5% to maybe 15% or 20% on the really aggressive side. But I think we’ll get into some of the drawbacks of having too much in liquid alternatives. But I think somewhere in that like 5% to 15% bucket seems reasonable.
How Popular Are Liquid Alts?
Dziubinski: Most investors get access to these liquid alts through some sort of managed product like a mutual fund or an ETF. So, how popular are liquid alts funds and are they growing in popularity?
Kephart: You know, it’s ebbed and flowed over time. You kind of see the flows as you’d expect. They tend to do better after liquid alts do well and not so well when liquid alts aren’t doing well. And it’s been a really great decade for traditional stock and bond portfolios. Come under a lot of fire recently, like in 2022, and the beginning of 2024 has been a little bit rough, too. But I think you’ve had such a strong market for traditional investments that liquid alts … there was a lot of demand and then there wasn’t. And now some funds are gaining demand, some funds aren’t.
Liquid Alts Investment Options
Dziubinski: Morningstar has several different investment categories for liquid alts funds split into two large buckets. The first being what Morningstar calls “portfolio diversifiers.” And the second large bucket is called “opportunistic.” Let’s start with those portfolio diversifiers. What sort of strategies fall into this bucket?
Kephart: The diversifier categories are those that really don’t have any market exposure. So it’s things like equity market-neutral, which is going to try to balance its long and short exposure so that the only return should be the difference between the long stocks and the short stocks. And there’s event-driven, where you’re making bets on whether or not company mergers will go through, and stuff like that that really shouldn’t be as impacted by what’s going on in the general stock market. So, those are kind of your diversifiers.
How Liquid Alts Portfolio Diversifier Strategies Work
Dziubinski: Can you walk through each of those strategies a little bit more and how they work?
Kephart: Equity market-neutral is you’ll have a traditional long-only type investment strategy. It could be factor-based or fundamental-based. But you’ll have a diversified long book and you’ll have an equal short book. So you might be 100% long, but then 100% short. So, your net equity exposures are going to be zero. And it’s not going to be perfectly zero, it’s going to be around negative 5%, plus 5%. But it’s a stock-picking strategy that’s betting the long picks outperform the short picks. Then with event-driven, you’re betting on corporate actions. When a company decides to take over another company, there’s always that period where you have to go through approvals. They actually have to seal the deal. You’re basically betting that those deals do go through. Those also tend to be relatively uncorrelated to what’s going on just in the general stock market going up and down.
How Successful Has the Portfolio Diversifier Bucket Been for Investors?
Dziubinski: How successful has this group of portfolio diversifier strategies been in terms of actually diversifying for investors?
Kephart: I think the challenge has been there’s a lot of dispersion of returns within these categories. Manager selection matters a lot more in alternatives than it does in large blend. Within large blend, as long as you avoid the real landmines, your range of returns is going to be pretty narrow relative to liquid alts. Liquid alts could be of a really wide range of returns. Multi-alternative is one of the categories and that’s one of the ones that puts a lot of different alternative categories together. It could have equity market-neutral, could have systematic trends, could have long-short equity, but the three-year returns for those range from more than 20% to negative. How you pick the manager really determines your success. That’s one of the challenges when choosing a liquid alts fund.
What Strategies Are Part of the Opportunistic Bucket for Liquid Alts?
Dziubinski: This other large bucket are opportunistic strategies. Talk a little bit about the types of strategies that qualify.
Kephart: I’d say the most interesting category within that bucket is systematic trend. We used to call it managed futures. We’ve evolved the name a little bit. Generally, these are trend-following strategies that when a market’s going up, it will be long, and when it’s going down, it will be short. In the past few years, it’s actually done pretty well because you had just such a downward-sloping path for fixed income that they were able to short the market and ride that down. It did really well in 2022 as a diversifier. So, systematic trend is one of those strategies that has delivered during really bad times for stocks and bonds. That’s also categorized as being very hard to own, I think, because it goes through very long stretches where it doesn’t deliver that well. But when the markets are trending strongly in one direction, it tends to do pretty well.
How Opportunistic Strategies Work
Dziubinski: How do some of these opportunistic strategies work?
Kephart: With trend-following, they’re looking at moving averages. They could have many different time horizons they look at. They’ll look at hundreds of different contracts even, like AQR Managed Futures AQMIX will trade anything from energy to cocoa oil. It could get very granular and niche, but they’re also trading stock market futures, stuff like that. So, there really is a very wide-ranging strategy, and it could be hard to make sense of from the outside looking in. But in general, you really have to believe in the manager’s ability to deliver what they say they’re going to deliver.
How Successful Has the Opportunistic Bucket Been for Investors?
Dziubinski: In this opportunistic bucket, again, how successful have the more opportunistic strategies been over time?
Kephart: Systematic trend was the real liquid alts standout in 2022. Most of them did double-digit returns, which really would have helped balance out what was going on in stock and bond markets. That’s been the real standout among all liquid alternatives. But again, it’s been one of those strategies that from 2013 through 2020 had a lot of down periods. But it is one of those insurance-type products that if you hold on to it, it does tend to work over the long term, but it can be painful to hold.
Ask Your Advisor These Questions Before Investing in Liquid Alts
Dziubinski: If this does sound compelling to an investor and their advisor is talking to them about it, what are those key questions they need to make sure that they’re asking before they’re going to dip a toe into liquid alts?
Kephart: The one big thing we haven’t touched on yet is fees. Liquid alts tend to come at a significant premium to traditional investments. So, you may be paying more than 1% in management fees, but if you’re keeping the allocation small, it might not make a big impact on your overall returns, but I think that’s one of the things to keep in mind. If you are going to go over that 15% mark, eventually you are going to really start adding some fees up there. But I think the other things to think about are where we are funding it from. Are we taking away from stocks and long-term growth potential? Because I think over the very long term, stocks would outperform most liquid alternatives, just on a total return basis. And then on the fixed-income side, if you’re taking away from that, your income is probably going to take a hit. There’s always these trade-offs. You want to know how the advisor is thinking about that and building the portfolio. How are they adding it to the portfolio? Those are the questions I want to ask.
Dziubinski: Well, Jason, thank you so much for your time today. We really appreciate it.
Kephart: Thanks for having me, Susan.
Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.
Watch The 60/40 Portfolio in 2025: What to Expect for more from Jason Kephart.
