Strong flows into liquid alternatives continue, but less than 5% of client assets at wirehouses are allocated to alternatives

Advisors need standardized ways to evaluate alternative mutual funds and ETFs

A recent study by Money Management Institute (MMI) and Dover Financial Research reports that alternative ETFs and mutual funds accounted for about 43% of the net flows at wirehouses in 2013. The total level of alternative assets held by clients in wirehouse accounts was approximately $172 billion in 2013 and 51% of these assets were invested in liquid-alternative products.  That’s up 44% from 2012 and 38% in 2011.  Amazing.

The report, however, also states, “Most investor portfolios have less than 5% of assets in alternatives, which is well below the 15% to 20% levels recommended for achieving proper portfolio diversification and investors’ objectives.”  We find this staggering.

What is holding advisors back from recommending liquid alternative funds?

Let’s first look at what advisors are buying.  The report states that 75% of the liquid alternative assets at wirehouses are concentrated in five “blockbuster” alternative mutual funds (a.k.a. ’40 Act alternatives) from MainStay, BlackRock and JP Morgan.  Why?  These “blockbusters” have investment performance, firm reputation and distribution.

Wirehouses are making progress in helping advisors understand the potential outcomes of using alternatives in client portfolios.  Morgan Stanley recently published a white paper that categorized alternative investments by outcome.  In this report, they clearly define and categorize these investments in the context of an overall asset allocation framework.

Additionally, we are seeing joint ventures between established hedge funds and mutual fund managers with significant distribution. These are game changers for advisor adoption of liquid alternative funds.  The influx of new offerings is exciting, but it also causes more confusion in the marketplace, as the industry still lacks a standardized method of defining, categorizing and evaluating these funds.

How do advisors currently evaluate liquid alt funds?

In the meantime, advisors are left to their own devices to evaluate liquid alternative funds.  They report to Ulicny that the top obstacle in recommending alternatives is their lack of conviction in the manager’s ability.  They tell us that many of the liquid alternative funds are “young” so it is difficult to see a track record or persistency of a manager’s performance.

Advisors report to us that they use hedge fund benchmarks to evaluate the performance of liquid alt funds.  For example, an advisor compares the performance of an event driven liquid alternative fund to the Hedge Fund Research Index (HFRI) Event Driven Index. But this is not an apples-to-apples comparison, as hedge fund performance is partly self-reported and can be influenced by factors such as survivorship bias.  In contrast, liquid alternative managers offer performance transparency and verification by third-parties such as Morningstar.

An interesting related study.

Cliffwater recently published a study that measured the performance of private alternative funds (hedge funds) versus liquid alternatives in a variety of structures.  They reported that the average annualized performance of hedge funds exceeded liquid alternatives by 0.98% and concluded that this is approximately the net discount that liquid alternative investors pay for their redemption privilege.

A possible apples-to-apples approach.

The MMI/Dover study states that alternative ETFs and mutual funds account for about 43% of net flows at wirehouses, so it appears that the advisor prefers to use the ETF and mutual fund structures to access alternatives.  One possibility is to go beyond the Cliffwater study and the compare the performance of the same manager who runs a similar style in both a private fund and mutual fund or ETF  to yield an apples-to-apples comparison.  Today, there appears to be a growing list of these managers with enough experience to describe the effect that liquidity constraints and performance costs have on their liquid-alternative funds, relative to their fee advantages.

We applaud the research efforts conducted in this area to date, but think we as an industry can do more.  If we want to see the current “less than 5%” allocation to alternatives move closer to the recommended 15 to 20% allocation, advisors must have a standardized way to compare and evaluate these investments. We believe that an advisor will not recommend a product to his client without having conviction in it.  We have seen, first-hand how knowledge fuels conviction and conviction fuels trust.

We encourage the continued discussion.  We believe that greater numbers of advisors will adopt liquid alternative funds when they have the tools they need to fulfill their fiduciary responsibility to their clients.

 

 

—May 2014