Why Liquid Alternatives Keep Disappointing — and What to Do About It
Most liquid alternative funds fail a simple test: they cannot be held through a full market cycle — adopted in crises, abandoned on recoveries, and gone before the next bear market arrives.
The liquid alternatives category has a lifecycle problem. Advisors and allocators adopt alternative strategies after a crisis, then abandon them when markets recover. The result: approximately 2,100 liquid alternative funds have gone extinct over the past 20 years, even as 1,536 remain active today.
The question for any serious allocator is not which alternative fund to own—it’s whether hedged equity, used as a permanent allocation, solves the problem that makes traditional liquid alternatives so difficult to buy and hold. This post, the third in a four-part series, examines how hedged equity functions as a structurally distinct alternative sleeve: maintaining meaningful equity participation in bull markets while actively managing drawdown risk in bear markets. By design, it is built to be held through the full cycle, not just the crisis.
What Investors Actually Want from a Liquid Alternative (And Why It’s Hard to Find)
Investors want all three simultaneously — full upside participation, meaningful downside protection, and low fees — and no single liquid alternative strategy reliably delivers all three.
Part of the problem is investors often have unrealistic expectations for their alternative investments. It seems like some investors want alternative investments to have the following features:
- All of the upside of traditional, long investments
- Significantly less downside than traditional investments
- Fees matching passively managed index funds
While these features are desirable, it seems unlikely that any single fund or investment strategy will feature all three of these characteristics simultaneously. The old saying “There is no free lunch” holds true in alternative strategies.
That said, many alternative strategies seek to maximize the tradeoff between upside capture and downside risk minimization. Swan’s Defined Risk Strategy (“DRS”) is one of those strategies.
How Hedged Equity Solves the Upside/Downside Trade-Off
Hedged equity solves the trade-off by keeping the portfolio fully invested in the equity market while using actively managed put options to flatten losses in bear markets — without capping gains in bull markets.
The Defined Risk Strategy (DRS) is deigned to mitigate losses when the market is down significantly, while still providing meaningful up-market participation. The driving idea behind the DRS is that large bear markets are too painful to endure, so the DRS is engineered to have a different risk-return profile than a traditional long position.
The Defined Risk Strategy is a hedged equity solution that utilizes put options to manage the upside/downside trade-off. Moreover, these put options are actively managed. Rather than being held to expiration, the DRS’s put options are sold when they still have value. The put options are sold well before expiration and new put options are purchased at current market levels as part of the actively managed “re-hedge” process. The re-hedges typically occur 1) near the end of the calendar year, halfway through the put options’ lifecycle, 2) following a deep market sell-off when the options are “in-the-money” and profitable, or 3) following a market run-up to ratchet up the levels of the hedge.
The strategy has been active since 1997 and has successfully weathered the largest bear markets this century: the Dot-Com Bust and the Global Financial Crisis, as well as other periods of major market stress like the 2010 Flash Crash, the Covid-19 selloff of 2020, the inflation bear market in 2022, the 2025 Tariff Tantrum and more.
One of the key charts that convey this message is the one below, referred to as the “Target Return Band”. We believe that our Target Return Band is a very appropriate prism through which our performance can be viewed. The three main elements of the Defined Risk Strategy are charted in this band:
- A long, buy-and-hold position in ETFs, typically representing 85%-90% of the portfolio (dark grey line)
- Long-dated put options (LEAPS) used to hedge market risk (gold line)
- Short-term, market-neutral premium collection trades to generate cash flow (light blue range)
Essentially a profit-loss diagram, this chart shows:
- the linear return profile (profit/loss) of investing in the S&P 500,
- the curved gold line represents the return profile of the DRS’s hedged equity position; that is, the buy-and-hold position in the market combined with the protective elements of the long-term put option hedge;
- the gold line lags the S&P 500 in up markets but is still upward sloping,
- the gold line flattens out in down markets as the S&P 500 continues to drop.
- the blue area around the gold curve is the anticipated range of impact from overlaying Swan’s short-term premium collection trades over the hedged equity position.
It is our goal that returns of the DRS will be within or above the blue shaded area. More often than not, they have been.
That said, there are many different ways to manage the upside/downside trade-off. Morningstar currently has two broad groups called “Nontraditional Equity” and “Alternative”, which have four and eight specific categories within them, respectively.
Mapping the Liquid Alternatives Universe: 12 Categories, $627B, and the Funds That Didn’t Survive
The liquid alternatives universe spans 12 Morningstar categories, $627.58 billion in AUM, and 1,536 active funds — alongside approximately 2,100 that no longer exist.
The categories within these two broad groupings are as follows:
Understanding liquid alternatives is very difficult. First, there is a very wide dispersion of strategies. Second, many strategies are complex or have unique drivers of returns.
- Long-Short strategies try to short underperforming stocks as well as own outperforming stocks. The drivers of return and risk in Long-Short strategies are primarily at the individual stock level.
- Macro Trading strategies make top-down decisions and reallocate their portfolios based upon the anticipated relative performance of asset classes. The fate of these Macro Trading is driven by systematic, market factors.
- Market Neutral strategies might try to have very low exposure to market movements, which is difficult to achieve given the rising correlations amongst many of the world’s asset classes.
- Option-based strategies have multiplied and are represented by three separate categories: Derivative Income, Equity Hedged, and Defined Outcome.
- The Multi-Strategy category tries to replicate the “fund of funds” structure employed by hedge funds by rolling many of the above strategies together in one package.
I could go on, but the point is that broad definition of “liquid alternatives” encapsulates many different strategies and trying to understand all the factors at play becomes very difficult to manage.
The Portfolio Impact of Liquid Alts and Hedged Equity
A 20% DRS allocation in a traditional 60/40 portfolio historically produced higher returns, lower volatility, and a better Sharpe ratio than the same allocation to the Morningstar Multistrategy liquid alt category average — over the same 28-year period.
The bias some investors have against liquid alts is based on data suggesting it simply isn’t worth the extra time, complexity, and additional cost of including liquid alternatives into a basic, traditional portfolio. The data below illustrates the impact of adding the Morningstar category average of diversified Multistrategy funds (listed in the table as “Liquid Alts”) to a traditional 60% S&P 500, 40% bond portfolio. 10% is redirected from both the equity and bond allocations, giving an overall 20% allocation to the Multistrategy category. For comparison, the same changes were made using Swan’s Defined Risk Strategy. Data shown is from the inception of the DRS, July 1 1997, through May 30, 2026.
Using a broad-based index as a proxy for liquid alternatives, it is easy to see why some investors remain unconvinced. The returns are less, the risks are higher, and the Sharpe ratio is lower than the traditional 60/40 portfolio.
However, when using a 20% allocation to Swan’s Defined Risk Strategy, the reverse is true: returns have historically been higher, risks lower, and the Sharpe ratio shows an improvement over the traditional 60/40.
The lack of compelling results from many liquid alternatives leads directly to the next section, which discusses the high level of “failed” or shut-down liquid alt mutual funds and ETFs.
The Liquid Alternatives Lifecycle: Why 2,100 Funds Have Gone Extinct
Approximately 2,100 liquid alternative funds have gone extinct over the past 20 years — even as 1,536 remain active today. The lifecycle pattern is consistent: assets surge after crises and drain in recoveries.
While the return drivers of different alt strategies vary, broad growth in liquid alternatives assets under management was driven by two, macro-level market events. The first was following the Global Financial Crisis of 2007-09 and the second was following the Covid-19 Pandemic. Both crises were marked by a steep market sell-off followed by an era of ultra-loose monetary conditions.
The liquid alternative space has also been marked by periods of shrinkage and consolidation. Although there are 1,536 funds in existence today, an in-depth study of Morningstar Direct’s data shows that around 2,100 alternative funds have gone extinct over the last 20 years.
The life cycle of alternative funds is not hard to discern:
- A financial crisis hits the markets
- The Fed lowers rates
- Investors seek out alternative assets for hedging, income, or non-correlated returns
- Markets stabilize and long-only investments return to favor
- Investors abandon alternative assets
- A new financial crisis hits; repeat the process
The unfortunate reality then is that alternatives are too often viewed as a “sometimes” asset class rather than an “always” asset class. During equity bull markets investors tend to abandon strategies that drag down overall portfolio performance too much. The lesson appears to be that if an alternative fund is to survive, if it is to be accepted as an “always” investment, it needs to provide enough upside market participation during bull markets.
Hedged Equity as a Permanent Alternatives Allocation: The Always Invested, Always Hedged Case
The DRS is built for permanent allocation — not tactical deployment — because it is designed to justify its place in a portfolio in bull markets, not just bear markets.
Due to the vicious Darwinism in liquid alternatives, the median inception date for active funds in this category is only August 2022. That means half of the funds in this broad category have not been battle-tested by the Dot-Com Bust, the Global Financial Crisis, or even the inflation bear market of 2022. The only significant market sell-off to occur since August 2022 was the brief “tariff tantrum” of early 2025.
On the other hand, Swan has been managing the Defined Risk Strategy for almost three decades. As an “Always Invested, Always Hedged” strategy, the DRS invests in the market and seeks meaningful participation during bull markets. The strategy is hedged in an attempt to mitigate the downside risk in bear markets. By balancing upside market participation with downside risk mitigation, the Swan Global Investments has been a survivor and a pioneer in hedged equity.
To see how hedged equity functions in other portfolio roles, continue the series:
Marc Odo, CFA®, FRM®, CAIA®, CIPM®, CFP®, Director of Research and Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy.
Important Notes and Disclosures:
Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms.
All Swan products utilize the Defined Risk Strategy ("DRS"), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results due to offering differences and comparing results among the Swan products and composites may be of limited use. All data used herein; including the statistical information, verification and performance reports are available upon request. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. Further information is available upon request by contacting the company directly at 970-382-8901 or www.swanglobalinvestments.com. 095-SGI-081426
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