Stocks and bonds are considered the main asset classes for investors while virtually everything else is labeled an “alternative.” Volatile stocks and low yields on bonds in recent years have led many investors to include asset classes outside of the mainstream, such as real estate, precious metals and commodities. Moreover, alternative investment strategies also fall into this broad category, and such strategies frequently are followed by hedge funds.
Historically, only wealthy investors have had access to hedge funds, but this has changed in recent years with the advent of so-called “liquid alts,” mutual funds and exchange traded funds (ETFs) that use the techniques of hedge funds. According to Morningstar, investors poured nearly $50 billion into liquid alts in 2013, bringing the total assets held by such funds to about $180 billion .
Going long and short
Originally, hedge funds literally offered investors a chance to hedge their positions in stocks. These funds bought issues the managers preferred (went “long,” in stock market parlance) and sold short shares of companies expected to lag. Thus, investors could make money in bull or bear markets, assuming the hedge fund had accurately guessed the relative performance of the stocks it selected.
Over the years, hedge funds have proliferated. Many of them follow strategies other than the classic long-short model. Different hedge funds might try to profit from merger arbitrage, buying distressed securities, dealing in derivatives such as futures contracts and options, focusing on bond market opportunities and so on.
The common denominator is that most hedge funds are not highly correlated to the broad stock or bond markets. This noncorrelation can play a valuable role in your portfolio, reducing volatility. If the stock market sinks,a hedge fund might have a smaller loss, or even a gain, improving overall investment results. Some hedge funds have performed very well, delivering superior returns as well as reduced portfolio risk.
That said, hedge funds have their drawbacks. They may have minimum investments of six or seven figures. Many of these funds use leverage that can magnify losses as well as gains. Transparency is low whereas fees are high . Perhaps most daunting, hedge funds aren’t liquid; investors might have an initial period with no access to their money, followed by monthly or quarterly redemption opportunities that require advance notice.
As the name indicates, liquid alts address these concerns. These vehicles are mutual funds or ETFs with modest minimum investments and daily access to your money. Liquid alts have some transparency, so investors know what they’re buying and holding. The mutual fund or ETF fee structure is familiar, if on the high side for many liquid alts.
The bottom line is that you now can get a fund that follows a hedge fund strategy for your portfolio, just as you’d invest in a stock or bond fund. There are long-short liquid alts, merger arbitrage liquid alts, and so on. Liquid alts often are managed by savvy professionals, including some led by people who also run private hedge funds.
Example: Ryan Rogers invests in ABC mutual fund, which has a $2,000 minimum. This fund goes both long and short in the stock market, as described previously. In addition, ABC sells call options on some of the stocks it owns-these options allow other investors to buy shares of the specific stock at a specific price. Revenues from selling the call options may help ABC in down markets, but this tactic also limits the fund’s upside.
Whenever he chooses, Ryan can add to his position in ABC or sell shares to raise cash. Ryan can buy ABC and other liquid alts in his taxable brokerage account, in his IRA, and in his 401(k) plan at work, if it’s on the list of available choices.
Finding a fit
The recent popularity of liquid alts indicates strong demand from investors. If you’re interested, be sure you do your homework carefully because liquid alts vary enormously in their methods and their results.
Last year, for example, some liquid alts with bearish strategies lost over 30% while other liquid alts that borrowed money to buy more stocks in last year’s bull market returned over 50%.
Generally, though, liquid alts tend to be defensive in their approach to the market . In 2013, when stocks surged and the average domestic equity fund returned over 30%, the average return for liquid alts was around 6%.Tactics such as short selling and covered call writing might be helpful in down years, such as 2000 and 2008, but they also can deprive investors of gains in bull markets.
Some advisers favor holding 5%-10% of a diversified portfolio in alternatives, including liquid alts. Potential advantages include
noncorrelation to other asset classes, the possibility of outstanding results in years when stocks or bonds
falter, and a long-term reduction in portfolio volatility.
The CPA Client Bulletin (ISSN 1942-7271) is prepared by AICPA staff for the clients of its members and other practitioners. The Bulletin carries no official authority, and its contents should not be acted upon without professional advice. Copyright ©2014 by the American Institute of Certified Public Accountants, Inc., New York, NY 10036-8775.
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