More and more these days, investment managers and investment advisors promote “liquid alternatives” as a replacement for high grade bonds in this environment of dramatically low interest rates. The idea is that bonds will earn a near-zero return because of the low yields and that investors would do better to shift their bond allocation towards liquid alternatives.
I have already explained why owning bonds in this low rate environment still makes sense for investors so I will not relitigate that argument. And before I explain why liquid alternative investments are not a sure-fire solution to low interest rates, it may first help to explain what is meant by “liquid alternatives”. In basic terms, “liquid alternatives” describes hedge fund strategies employed in a mutual fund or exchange traded fund (ETF) structure. In more advanced syntax, this includes hedge fund strategies like long-short equity, relative value arbitrage, distressed debt, and other absolute return strategies run under the structure of a fund that provides regular liquidity (unlike hedge funds run as limited partnerships which typically only allow investors to redeem their investments every 3-24 months, depending on the strategy).
It is also important to be clear on one thing: I am not an opponent of alternative investments. I fundamentally believe that alternative investments – employed in the right structure – can be very useful for diversifying portfolios. As a matter of fact, I launched and managed a hedge fund of funds in a limited partnership format as the chief investment officer for a large registered investment advisor. The primary objective was to give our clients simplified exposure to uncorrelated, “absolute return” investments beyond traditional stocks and bonds.
That said, I believe that investors who look to liquid alternatives as a significant replacement for bonds in this low rate environment are potentially doing far more harm than good. Consider four primary reasons why I believe this to be true:
1) Most liquid alternative investment returns are directly linked to interest rates. Low interest rates mean lower expected returns for liquid alts.
Nearly 100% of absolute return funds and other alternative investment strategies use some form of leverage – whether it is borrowing assets to short, purchasing futures contracts (inherent leverage), employing swaps (inherent leverage), or using other forms of leverage. Any time that leverage is used, the fund holds collateral to protect the counterparty. This collateral is usually some form of safe, liquid asset such as 90-day Treasury Bills. The net result is that a component of the return from alternative investments comes from interest rates. All else equal – when rates are low, alternative investment returns are lower because the return on the collateral declines.
How significant is this relationship? According to a regression of the HFRX Absolute Return Index over 36-month intervals since 1998, the 90-day Treasury Bill rate over the same periods explained 67% of the HFRX Index return. From a statistical standpoint, this significant relationship should abruptly discredit the idea that alternative investments are immune from low interest rates. Regrettably, most investors or financial advisors fail to appreciate the strong connection between alternative investment strategies and interest rates. And the fairy tale of liquid alternatives being a place to hide from low interest rates suits the alternative investment industry quite well and so there is no incentive to correct this fallacy.
2) Liquid alternatives face the same supply/demand challenge as traditional investments.
To be clear, the world is awash in liquidity. The Federal Reserve and other central banks have spent the past 13 years pumping cash into the financial system to fight deflationary forces and the result is too much cash chasing too few investments. It is fair to call this environment a global liquidity glut. As a result, we have interest rates hovering near historic lows, junk bond yields at record lows, and stocks at their richest valuations on record save for the final months of the dot-com boom.
Alternative investment strategies do not exist in a vacuum. Investors with excess cash seek out alternatives to stocks and bonds, offering explanation to the dramatic demand for investments like NFTs and cryptocurrencies. There may be pockets of opportunity but massive inflows into hedge fund strategies chasing the same opportunities reduce relative value spreads, arbitrage spreads, and distressed debt yields, resulting in lower expected returns for investors.
3) Alternative investments fail to offer dependable protection during stock market shocks.
The global financial crisis in 2008 provided the spark for liquid alternative mutual funds. Investors pursued anything that offered protection during bear markets and alternative investment mutual funds were quick to promote such protection. The problem became one of overpromise and under-delivery. While most alternative investment mutual funds have managed to avoid the same level of stock market declines during market selloffs over the past decade, they have also overwhelmingly failed to provide protection.
Consider the most extreme stock market losses of the past decade when the novel coronavirus sparked a dramatic selloff in stocks during the 1st quarter of 2020. Of the nine largest hedge fund strategy mutual funds, none delivered positive returns during the stock market selloff and the average performance of the funds during this period was -15.4%.
While many of these liquid alternative funds may have outperformed stocks, they did not exactly provide insurance or protection. Alternatively, an investment in long term Treasury bonds over the same 22 trading day period achieved a positive 13% return.
4) Liquid alternative mutual funds have a lousy track record.
Since day one, the marketing pitch of liquid alternative mutual funds has been: “We are going to bring the same best of breed alternative strategies that large pensions and endowments utilize to the masses in a liquid, low fee structure.”
But here is the first big challenge that has existed since the beginning: the best hedge fund managers – the ones with a unique advantage – can make approximately 10x more money with a fee tied to performance in a limited partnership format than what they can make managing money within a mutual fund. In a capitalist society where the scarce resource is talent, it makes sense that the managers with an advantage or skill will go where they can get paid the most (managing via a limited partnership structure) and the managers without any real advantage are just happy to get paid (managing via a pooled mutual fund structure).
The second big problem is that the best hedge fund strategies do not work in a daily liquid mutual fund structure. Some require more leverage than the structure permits. Other strategies use investments that the structure does not allow. Still more use illiquid investments that require holding periods of years rather than days or weeks and would blow up a daily liquid mutual fund. Mutual fund sales departments overlooked these hurdles (still do), catering instead to the demand and the fees they could earn. One hedge fund manager describes it well: “The main issue with liquid alts is you are trying to put a square peg in a round hold. You can push liquidity only so far for a hedge fund strategy before they lose their ability to generate alpha. Investors are starting to figure this out.”
A third big challenge for these investments is that while the fees may be lower than limited partnership alternative investment funds, they are still egregiously high relative to most stock and bond mutual funds. Those fees are easier to overlook when interest rates are high and returns approach double digits but they provide a dramatic hurdle when rates are low and returns are in the low single digits.
As a result of these challenges, the absolute return, hedge fund, and private equity strategies available as daily liquid mutual funds are overwhelmingly garbage. The dismal track record bears this out as evidenced here, here, here, and here. Nearly all the alternative investment mutual funds that launched with fanfare in the 2005-2010 timeframe have either shutdown or delivered unimpressive returns.
Closing Comments
I would love to honestly say that there is a great place to hide from low interest rates – an investment category that could still produce attractive returns while providing stability and protection from stock market selloffs. There is not. Rebalancing from bonds to some other alternative investment category just trades one risk for another.
The allure of liquid alternative investments seems to be that they are not bonds and that they can provide more attractive returns in a low rate environment. Perhaps. But investors are being fooled by Wall Street and the investment advisor community if they are led to believe that liquid alternative investments are the ideal solution to low interest rates. Caveat emptor.