Larkin Point Investment Advisors LLC

Liquid alternative mutual funds have become a popular investment category, but they are not easily described by a single label. “Liquid alts” tend to exhibit risk, return, and regulatory characteristics unique to particular strategies.

The multi-alternative fund sector attempts to achieve returns through exposure to an aggregated portfolio of different alternative investment strategies. Although some index providers use the multi-alternative label to describe a wide swath of investing strategies, the term probably is most accurately attached to liquid alternative funds of funds, funds utilizing multiple submanagers, and statistical factor replication strategies.

Several types of strategy groups invest across multiple asset classes, dynamically adjusting relative exposures at the discretion of the manager. Two commonly offered dynamic asset-allocation strategies are tactical and global macro.

Arbitrage strategies attempt to take advantage of price discrepancies between related securities by offsetting long and short positions in economically linked instruments. Merger arbitrage, for example, typically entails buying the stock of a takeover candidate and shorting the acquiring company.

The risk-parity portfolio technique offers an alternative portfolio construction methodology to heuristic rules such as “60/40” and traditional quantitative portfolio construction techniques such as mean-variance optimization. Proponents of risk-parity portfolios argue that the traditional 60/40 allocation historically has exposed investors disproportionately to equity market risk and that volatility in these historical returns has been driven primarily by variation in equity market prices.

The alternative-asset beta family of related liquid alternative strategies invests in alternative assets such as foreign exchange, commodities, and energy infrastructure. Ideally, these investments will provide attractive risk-adjusted returns that are uncorrelated with traditional equity and fixed-income markets.

Managed futures strategies date back several decades to the emergence of commodity trading advisors, which were first formally defined as a structure by the Commodity Futures Trading Commission Act of 1974 (CFTC). This type of strategy is also often offered through commodity pool operator vehicles, which are a similar and inter-related designation also primarily regulated by the CFTC.

Some equity funds may add option hedges in an effort to dampen portfolio volatility, generate alpha, and reduce tail risk. 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, put-writing, and more-complicated strategies—allow managers to potentially exploit the nonlinear characteristics of option payoffs to shape the return distribution.

Equity long/short strategies construct portfolios consisting of both long and short positions in equity securities and equity-linked derivatives but maintain an overall long bias with significant positive correlation to the overall equity market.

For the past 30 years, the paradigm portfolio holding 60-percent stocks and 40-percent government debt seemed to exhibit a reasonable mix of both growth and protection, being a simple allocation the market beta of two very liquid asset classes with low (occasionally negative) correlation.

The recent growth of mutual funds offering a wide array of liquid alternative strategies has raised questions among many advisors about the possible drawbacks of attempting alternative strategies within a 1940 Act vehicle.

Many advisors may view alternative investments as diversifiers in portfolios: satellite investments added to a portfolio of stocks and bonds in an attempt to “hedge,” or counterbalance a specific risk the advisor believes is not completely addressed by the stock/bond core. For example, real assets such as gold and real estate are alternatives that may be added to portfolios for inflation protection because advisors expect real assets to rise in value with any overall increase in wages and prices.

Many advisors may view alternative investments as diversifiers in portfolios: satellite investments added to a portfolio of stocks and bonds in an attempt to “hedge,” or counterbalance a specific risk the advisor believes is not completely addressed by the stock/bond core. For example, real assets such as gold and real estate are alternatives that may be added to portfolios for inflation protection because advisors expect real assets to rise in value with any overall increase in wages and prices.

Because modern portfolio theory emphasizes the value of holding instruments having low cross-correlations, we’ve heard many advisors describe the search for alternative investments as a search for assets with low correlations to either equities or bonds. This leads advisors too often to consider nontraditional assets over alternative strategies. We believe that perspective is too narrow and misses the larger point. It is our opinion that clients primarily desire reasonable returns with low volatility, and that there are many ways to achieve that goal.

We review a collection of nontraditional assets and acknowledge the growing attempts to offer more liquid instruments with market exposure to these assets. However, it is our opinion that these assets will ultimately represent a small portion of the overall allocation to alternative investments.