One of the big criticisms of many alternative investments, particularly for retail investors, is their poor or uncertain liquidity. This was highlighted in the GFC for small and large investors alike, as a range of alternatives funds failed, suspended redemptions, or were difficult to exit at other than significant discounts to full value. As a result, some retail investors remain cautious about alternative investments, demanding greater and more reliable liquidity. Fortunately, the scope for retail investors to access and build portfolios of reliably liquid alternative strategies and assets continues to improve.
First, let’s clarify what we mean by ‘alternative investments’. A simple definition is any investment that is not one of the traditional asset types of cash, bonds and equities. It is broader than simply ‘hedge funds’ and includes precious metals, commodities, private equity and ‘quasi alternatives’ like listed infrastructure and property.
Divergent liquidity preferences
It seems retail investors have developed two broadly divergent preferences regarding liquidity on investment products in the wake of the GFC. On the one hand they desire that the bulk of their investments provide very high liquidity, ideally daily or perhaps weekly. On the other hand, they will accept highly illiquid investments in asset classes they know well, typically with a defined future date for repayment or a liquidity event, such as a property syndicate. Ownership of direct residential and commercial property is another low liquidity asset. Investments that don’t easily fit into these two broad categories from a liquidity perspective are generally being shunned.
The good news is that the ability of retail investors to access liquid alternative investments has improved in recent years and is allowing portfolios to contain a meaningful allocation to a range of alternative investments while remaining highly liquid. This is occurring at a time when alternative allocations up to 30% are being recommended by some asset consultants and research houses. Of course these liquidity-focused investors are not able to access the extensive universe of alternative asset and strategy opportunities that long term institutional pools of capital such as large super or endowment funds can, but nevertheless the choice is clearly expanding.
Availability of alternatives
Liquid strategies like managed futures have become well accepted by retail investors in recent years as major groups like Winton, Aspect and AHL have entered the market. Long/short equity is increasingly a strategy offered by mainstream and alternative managers with more frequent liquidity than the monthly or quarterly liquidity offered by standard hedge funds. There are also a small number of highly liquid global macro, Tactical Asset Allocation (TAA) funds and commodity-related funds. Other ‘quasi alternative’ categories like listed infrastructure funds have also proliferated in recent years.
Part of this trend to greater liquidity is being driven by the response of hedge funds and fund of hedge funds to the GFC. Hedge fund of funds groups in particular have been forced to totally re-work their offer, especially if they are intending to appeal to retail investors. Many have built managed account structures to access individual hedge funds that allow greater liquidity, transparency and lower cost. The growth of hedge fund beta products (that is, they earn a hedge fund return rather than the return of a specific manager) that offer lower cost and more liquid access to hedge fund diversification benefits has also expanded the retail universe.
Another driver to greater liquidity has been the desire of fund managers to offer their products in the US mutual fund market and European listed markets. These structures require much greater liquidity as well as having restrictions on leverage and compensation arrangements. Managed futures, long short, market neutral equity, merger and event arbitrage as well as more diversified fund offerings such as hedge fund beta and fund of funds are being designed for these markets, and the structures can then be replicated in Australia.
Exchange traded funds (ETFs) are also growing as a way to offer some alternatives despite greater restrictions that this structure offers. For example, precious metal and commodity ETFs have grown rapidly in global markets in recent years, and are readily traded on the ASX.
Another small but often neglected area of liquid alternatives is listed investment companies (LICs). The advantage of this structure is that it can provide daily liquidity to those alternatives strategies that are inherently illiquid via trading on the exchange. Most prominent of these is private equity and debt although some less liquid hedge fund strategies and specialist areas like agriculture and timber have also been offered in this structure.
Of course this structure comes with some limitations, such as less manager choice, occasionally bad governance, and the tendency to trade up and down with the market irrespective of the value of the underlying strategy, which can dilute diversification benefits. Related to this is the tendency of these vehicles to trade at a discount or premium to Net Tangible Assets (NTA), although approached with discipline this can provide opportunities. If investors can be selective regarding manager quality and only buy LICs when they are trading at discounts to realistic NTA and where there are catalysts for that discount to narrow, these vehicles can provide very attractive returns. Such listed fund investments can be valuable satellite holdings or a complement to a broader liquid alternatives portfolio.
Consider as part of a portfolio mix
The liquid alternatives universe is clearly growing and enabling the construction of increasingly robust alternative portfolios for retail investors, something that would have been difficult to achieve just a few years ago. Of course, having a greater array of liquid alternatives to choose from does not necessarily make selecting them or building a portfolio an easy task given the complexity of many alternative assets and strategies. Further, there are many high quality alternatives managers and strategies that are difficult for retail investors to access for reasons other than liquidity, such as those without an Australian presence or operating only through offshore funds. This highlights the role that professionally managed pooled alternative vehicles, even if focused on mostly liquid funds, can provide.
Investors should welcome the greater availability of liquid alternatives, particularly in a world where expected returns over coming years on a range of mainstream assets classes are subdued and the risk-reducing and diversification benefits of a well-selected range of alternative investments are increasingly valued.
Dominic McCormick is Chief Investment Officer and Executive Director at Select Asset Management.