losses.
If you, too, have personally lived through all the market events mentioned – and particularly if you've lived through a few more even further back in time – you are probably not in a position to suffer the impacts of another market meltdown. You're simply too vulnerable at this stage of your savings and investing horizon to sit tight and let the corrections right themselves. You are also likely to be in need of generating income and at least keeping pace with inflation, if not rising health care costs. Stuffing mattresses and rolling over certificates of deposit (CDs) aren't very good options, yet traditional asset allocation across stocks, bonds, and cash also seems insufficient. The most recent market meltdown certainly taught us that when old-guard asset classes “correlated to one and went to zero” (which means the offsetting zigs and zags all zigged or zagged together), substantial losses were seen even in strategically designed asset allocation products incorporating the usually reliable diversification tools wielded by professional managers.
New tools are needed that are almost custom-tailored to behave in a certain way. For example, we as investors would surely benefit from a product that will diversify equity risk during a rocky equity market, or a product that has bondlike characteristics yet is designed not to follow the rest of the bond world down during a rising interest rate environment. At a high level, the implicit usefulness of such products seems too simple and too obvious to ignore. Who wouldn't want to use such vehicles in one's portfolio if – and this is a big if– they truly exist and perform as advertised?
Well, the investment management industry is nothing if not resourceful and forever inventive, and it is this zeal to create – or at least repackage – that is bringing investors just such products in an easy-to-access mutual fund form. Liquid alts give the average investor access to sophisticated strategies that had once been reserved exclusively for high-net-worth investors, so mutual funds and exchange-traded funds (ETFs) truly are “democratizing alts.” Unfortunately, the fund industry also has a tendency to blithely follow flavor-of-the-month trends in investor demand and to crank out ill-conceived efforts and rushed product designs in order to participate in the next big thing. All they need to do is label it in a compelling way, and investors may blindly buy in (Internet funds, anyone?). This is why you are reading a book like this.
For all of the foregoing reasons, my colleagues at Lipper and I believe that understanding alternatives is an important, if not critical step for investors and advisors who desire to build better diversified portfolios. With the aging demographics of the developed world, such products are a must in order for individuals to build secure retirements and protect their nest eggs. Even younger investors can benefit from products that help navigate market volatilities stemming from such newfound sources as high-frequency trading, derivative-laden structured products, and the massive ebb and flow of herd-mentality asset class gyrations – any of which can cause substantial disruptions to the normally sanguine process of putting aside part of your paycheck for your eventual retirement.
Liquid or registered alternatives are a relatively young corner of the industry and, as mentioned already, not everything that is being marketed out there as an alternative fund is well labeled or well designed. Complicating matters further is the fact that the investment industry loves to wax philosophical and craft sweeping white papers and books with Greek letters, long formulas, and big words to give the appearance that they are incredibly smart and deserving of your money. Any one of these tomes, when read by even sophisticated investors, leaves one with the feeling that this truly is the best product out there and is being run by the smartest people in the industry. An additional complication is that there are many of these products that hail from the once-sacrosanct world of hedge funds. Simply because they are run by a former or current hedge fund manager doesn't mean they have any business in your portfolio. The goal of this book is to take a third-party view of this fast-growing segment of the fund industry. The authors aren't tied to any of the major firms launching and running these funds, and they haven't been involved in any of these product designs. Furthermore, no one involved with the writing of this book stands to gain from sales of alternative investment products as a result of their being profiled in this book.
With conflicts of interest removed, what remains is a factually based reference manual that describes the major categories of what are known as liquid alternative funds with descriptions of what they are, how they are designed and managed, how they perform, and how an advisor or investor might consider using them in a portfolio. This book offers a simple, practical guide that helps investors benefit from their newfound access to advanced strategies. This brings power back to the investor and is the democratization of alternatives.
Acknowledgments
We would like to thank everyone at Lipper, including Robert Jenkins, Global Head of Research; Andrew Clark, Head of Alternatives Research; and Tom Roseen, Head of Research Services. At John Wiley & Sons we thank Tula Batanchiev, Associate Editor, and Judy Howarth, Senior Development Editor, as well as all of the other professionals who helped make this book a reality. We thank Owen Zukovich, Client Service Associate at Morgan Stanley Wealth Management, for data analysis and preparation of the tables and figures.
We also thank all of the interviewees for their time, candor, and insights.
Introduction
The allure of hedge funds has enthralled investors since the pioneering work of Alfred Winslow Jones in 1949. Talented money managers have traditionally emerged from the incubator of large institutions prior to gleaning capital from family and friends as a means to launch their own hedge funds, often in the Big Apple. Distant from the Securities and Exchange Commission (SEC) and largely unregulated, hedge fund managers have often employed obscure and complex strategies to generate alpha (excess return or outperformance relative to their benchmarks), and this has allowed the notoriously lucrative “2 and 20 percent” fee structure. Hedge funds are also notorious for their illiquidity, lack of transparency, and high investment minimums. Nevertheless, hedge funds remain an exclusive club that attracts high-net-worth and institutional clients, while being out of reach for the average investor.
That is, until these sophisticated strategies were democratized in the form of Investment Company Act of 1940 ('40 Act) wrappers (i.e., mutual funds), thereby giving hedge fund managers access to the retail market. For some top-tier managers, small accounts are time-consuming and burdensome, but other managers recognize the opportunity to expand their footprints through retail distribution of their hedge fund strategies. Their efforts are paying off, and this book will explore the rapid growth of the liquid alts space.
Why do we say “democratized”? Because liquid alts have extended access to hedge fund strategies to investors on Main Street. Mutual funds have used leverage and short selling for decades, and these are the same strategies that trailblazer Alfred Winslow Jones used in the first pooled investment vehicle that focused on alternative investment strategies. But recent product innovation has propelled the growth of liquid alts to new heights as these products reach a much broader base of investors. The proliferation of products peaked in the middle of the preceding decade with the launch of dozens of alternative mutual funds. These new products are similar to traditional hedge funds in their use of leverage and the ability to go both long and short in equity, fixed income, currencies, commodities, and derivative instruments. Thus, '40 Act alts democratize access by empowering both high-net-worth and retail investors with sophisticated investment strategies.
In addition to expanding access, liquid alts offer benefits that differ in key ways from traditional hedge funds. The '40 Act products have disclosure requirements that help protect investors and that make the products more transparent. Liquid alts also have lower investment minimums, greater tax efficiency, and lower expense ratios. Thus, these funds offer diversification benefits and potential alpha that had been available only to the upper echelons of the income scale by way of traditional hedge funds.
The democratization of hedge
