Liquid Alternative Strategies as Mutual Funds
We believe that the recent growth of mutual funds, registered under the Investment Company Act of 1940 (“’40 Act”) and also known as Registered Investment Companies (“RICs”), offering a wide array of liquid alternative strategies has raised questions among many advisors about the possible drawbacks of attempting alternative strategies within a ’40 Act vehicle.
There are four main areas of concern among advisors:
- Whether limits on leverage in open-end funds dampen returns vis-à-vis hedge funds;
- Whether limits on illiquid investments held and the restrictions on concentration limit potential returns;
- Whether daily pricing and redemption requirements require investment choices or cash holdings that potentially limit returns;
- Whether the absence of performance fees discourage the retention of the best managers.
Many of these concerns are valid, in our opinion, especially as they relate to alternative strategies that involve inherently illiquid asset classes. But we also believe that many strategies used by hedge fund managers can be easily executed within the constraints of the ’40 Act. In fact, we see many hedge fund strategies that use highly liquid exchange-traded funds (ETFs) as core holdings or for short positions, and we see many which employ options – all of which can be used in alternative mutual funds.
Other “limitations” of the mutual fund structure – restrictions on leverage, for example, and the need for greater liquidity – may ironically serve to encourage less risky behavior on the part of managers, as may the absence of incentive fees. Lower fees also may result in greater investor returns.
Liquid Alternative Mutual Funds: An Overview
Long/Short Equity and Hedged Equity
This strategy typically combines long and short positions in individual equities and equity-linked derivatives with the goal of dampening portfolio volatility and risk. Long-short funds, however, tend to have a long bias and tend, therefore, to be positively correlated to the equity market.
Many long-short funds utilize simple linear hedges in which they short individual equities or exchange-traded funds, relying on manager skill to generate alpha and dampen volatility through stock selection, sector allocation or market timing.
Equity Market-Neutral
Similar to long-short equity strategies in their goal of dampening volatility and risk, equity market-neutral strategies are distinguished by the absence of a systematic long-equity bias. Targeted exposures are typically close to market neutral. The Morningstar fund classification system, for example, specifies equity index betas between -0.30 and +0.30 for consideration in this category. Fund returns are therefore primarily driven by the fund manager’s ability to generate positive alpha in excess of fees. Fund strategies typically attempt to accomplish this feat through stock selection, market-timing and arbitrage strategies.
Equity Arbitrage
Long/short equity funds also include various forms of equity arbitrage funds including but not limited to merger arbitrage and convertible arbitrage. In both instances, managers select securities that are believed to have some economic linkage but in which the manager also believes one security in which a long position is established will outperform another security in which a short position is established. Buying a stock of a takeover candidate and shorting the acquiring company’s stock is typical in merger arbitrage.
Option-Based Long/Short Equity
Other equity funds add option hedges in efforts to dampen portfolio volatility, generate alpha and reduce tail risk. We believe option hedges provide a vehicle for potential alpha, allowing tactical managers to express multi-dimensional views on security price, volatility and time. Systematic option strategies, which include covered-call, collar, and put writing may allow managers to potentially exploit the non-linear characteristics of option payoffs to shape the return distribution. These systematic options strategies often sell options to capture what is referred to in academic literature as the volatility risk premium, or a measure of the extra return investors demand in order to hold a volatile security. Some funds also strategically purchase options with the aim of mitigating the impact of tail events.
Volatility Strategies
A small but growing number of mutual funds attempt to exploit the tendency of equity market volatility to rise in market sell-offs through the purchase and sale of volatility-based futures contracts and exchange-traded notes that are tied directly or indirectly to the VIX futures contract. These funds differ from options-based long/short equity strategies as volatility is considered to be an entirely separate asset class managed without integrated positions in the underlying securities.
Unconstrained Fixed Income
This somewhat ambiguous label can be applied to a large swath of fixed-income funds that are not tied to a traditional bond market benchmark. These alternative fixed-income funds often have freedom to shift allocation across multiple segments of the fixed- income universe. Many employ derivatives. Others permit short sales. This flexibility facilitates targeted exposure to interest rate (duration risk) and credit risk (default risk) at the manager’s discretion within each fund’s mandate.
Tactical Allocation
Tactical allocation funds continuously adjust allocation among designated asset classes in accordance with manager discretion. The returns of these strategies are highly dependent on market timing and manager skill. History has shown that mistimed allocation can result in losses even during periods when all underlying markets rise.
Multi-alternatives and Multi-strategy
The multi-alternative fund sector attempts to achieve returns through exposure to an aggregated portfolio of different alternative investment strategies. This is typically achieved through either a portfolio of other RICs or through management of several sub-advisors. Some multi-alternative funds attempt to recreate the statistical factor exposures of an alternative index through a combination of traditional securities. In our opinion, this type of fund can provide a convenient vehicle for exposure to multiple alternative strategies, although we believe it is important to consider all levels of management fees and performance.
Risk Parity
The risk parity investment philosophy is in many ways an extrapolation of key concepts first outlined by Harry Markowitz in the 1950s. Risk-parity funds construct portfolios by adjusting the weight of each asset class so that the expected risk contribution of each asset class is equal. This “optimal portfolio” is then levered or delivered in accordance with a desired overall risk exposure. In practice, this technique results in portfolios heavily weighted toward fixed-income and, sometimes, commodities, which then are significantly levered.
Managed Futures
Managed futures within a ’40 Act fund are the latest iteration of futures strategies that originated in the Commodity Trading Advisor (CTA) community. As the description implies, managed futures funds invest primarily in futures contracts, although many may also use options and over-the-counter derivatives. The large number of underlying commodities now covered in the global futures markets allows managed futures funds to trade and provide a proxy for a large set of asset classes, including fixed-income, traditional agricultural and natural resource commodities, equity indices and foreign exchange. The vast majority of these funds employ trend-following strategies, although a few funds also utilize other quantitative methods or fundamental analysis. Proponents of managed futures strategies often cite commodities’ historically low correlation with changes in equity prices and the structure’s ability to earn interest on cash held as collateral.
Managed futures strategies structured within a RIC often adopt a relatively complex legal structure to comply with the US tax code. In response to the “Qualifying Income Test” enumerated in Internal Revenue Code section 851(b)(2), many of these funds are structured with wholly owned offshore subsidiaries designed to pass trading gains back to the parent fund as dividend income.
DISCLOSURE
Larkin Point Investment Advisors LLC (“Larkin Point”) is an investment advisor registered with the U.S Securities and Exchange Commission. Registration with the U.S Securities and Exchange Commission does not constitute an endorsement of the firm by the Commission, nor does it indicate that Larkin Point has attained a particular level of skill or ability. Larkin Point is not a registered broker-dealer in the United States. Larkin Point is not registered under the laws of any foreign jurisdiction and this report shall not be deemed a solicitation of any investors or clients in contravention of any such foreign laws and regulations.
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This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein.
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