Liquid alternatives (or “alts” for short) are investment vehicles that are thought to provide diversification benefits to traditional portfolios composed of stocks and bonds. They often come in the form of exchange-traded funds (ETFs) or mutual funds. Liquid alts are aimed at retail investors who would otherwise not have access to areas such as hedge funds and complex products aimed at high net worth investors.
This niche group of assets contains strategies that may be opaque to novice investors, so it often helps to work with an experienced financial advisor when venturing into the space. Those interested in adding liquid alternatives to their portfolios should first carefully consider their risk and return objectives. It is also important to understand what are often high and non-transparent fee arrangements with liquid alts.
What types of liquid alts are there?
Liquid alternative investments may initially be thought of as some sort of hedge fund-like strategy, but there are many other types offered to everyday investors in today’s landscape. Available today are liquid alternative investments based on macro event trading, options (puts and calls), market neutral strategies, trend following algorithms, long-short positioning and non-traditional bonds.
At a high level, liquid alts are products that are not typical long-only stock or fixed income funds. Types of assets found in liquid alternative strategies include real estate, wine, art, commodities, private equity, and distressed debt.
Many of these investments are not easy to buy and sell. Unlike large-cap US stocks, it’s not as simple as clicking a button to execute trades during the trading day. Tailor-made markets exist and, in some cases, time-consuming bilateral deals have to be made. Still, the ETF wrapper makes buying and selling efficient with liquid alts.
Who can buy them and why?
For the most part, any investor interested in alternative investments can buy alts. You only need a brokerage account to house the ETF or mutual fund. Unlike most hedge funds, you don’t have to be an accredited investor. However, there may still be increased minimum investment requirements for some mutual funds. The ETF wrapper allows you to join the game as long as you have enough capital to buy a single share.
Liquid alts can be particularly attractive to investors looking to diversify their portfolios of index stocks and bond funds. After all, everyone wants investments that zigzag when other assets saw. Investors also seek the perceived safety of some alternative areas when the stock market becomes volatile. The downside is that once winning strategies can suddenly underperform when market regimes shift.
Consider the popularity of managed futures shortly after the Great Financial Crisis – managed futures performed incredibly well compared to stocks in 2007-09, but then produced mediocre returns after money poured in. Therefore, investors should carefully weigh the risks and rewards of liquid alts so that they understand the potential dangers of these sometimes complex strategies.
What type of account should an investor place Liquid Alts on?
Before putting money to work in cash, you need to understand how they work for tax purposes. In general, the location of assets suggests that investments with a high tax-to-expense ratio should go into tax-sheltered accounts such as an IRA. Some investors even have access to a broker-linked 401(k) account within their employer’s plan. Tax-efficient assets, such as low-dividend stocks, are considered better for taxable accounts because they often don’t result in an individual’s tax bill.
Some cash can pay a large annual dividend or provide a significant income stream. For that reason, it can make sense to place some liquid alts in a tax-advantaged account.
What do financial advisors say about using Liquid Alts for their clients?
Darryl Lyons, CFP®, ChFC®, BFA, AIF Fee-Based Fiduciary Advisor
Liquid alternatives are used when fixed income solutions do not have a favorable risk-reward profile. This happens when fixed-income yields are low, bonds are bought at a premium, and rising interest rates are looming.
Liquid alternatives can provide a diversification benefit if they are not highly correlated with the market. My preference is for the active fund space so that there is management oversight and the flexibility to switch strategies in different market cycles and events.
Fees are generally higher, so fee-sensitive investors should put up with the idea of adding more operating expenses to the portfolio. Many of the liquid alternatives are in the futures space using commodities, currencies and interest rates.
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Darryl Lyons, CFP®, ChFC®, BFA, AIF | PAX Financial Group
🔗 Website | Asset manager profile
Adell, Harriman & Carpenter, Inc. Your financial home for every season of life.
We tend to invest in listed alternative asset managers. Those vehicles can give investors access to private equity, venture capital, private credit and various hedge fund strategies.
Such approaches can be challenging to replicate or hold in fund-like structures that are repayable or subject to different regulatory limits. We tend to buy into things that we expect to own for a long time, but an added benefit of investing in alt through publicly traded stocks is that holding companies are not subject to any mandatory liquidity restrictions or windows.
– Scot Johnson, CFA | Head and Chief Investment Officer
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Adell, Harriman & Carpenter, Inc.
🔗 Website | Asset manager profile
Liquid alts are hedge fund-like products aimed at retail investors. Their liquidity and lower costs compared to traditional hedge funds may seem attractive to investors, but high fees and sketchy long-term performance are risks to be aware of. Working with an experienced and knowledgeable advisor can go a long way in ensuring that cash fits into a long-term financial plan. Especially if you expect to move beyond liquid alternatives to more traditional alternative investments, consider hiring an advisor who has earned the Chartered Alternative Investment Analyst (CAIA) designation.
Frequently Asked Questions
Are hedge funds liquid alternatives?
No, hedge funds have a separate strategy and structure. It is common for a hedge fund to require very high investment minimums and a long commitment period from its investors. In addition, a hedge fund usually has an additional performance-related fee. For example, the general partner of a hedge fund may charge a 2% annual fee on assets and a 20% fee on profits. A hedge fund’s positions are not always known, while an ETF must disclose its positions on a daily basis.
How are the fees?
Expect higher costs with a liquid alt fund compared to a typical index ETF. While most liquid alternative products may not have as high a fee burden as a hedge fund, they will cost you more. The expense ratios can go up to 1% or more every year.
Is my money locked up for a long time?
No, one of the advantages of liquid alternatives is that there is intra-day liquidity and there are no restrictions on when you need to access your capital. Still, there can be high bid/ask spreads on a liquid alt ETF. Mutual funds, on the other hand, are priced once a day after close of trading at the fund’s net asset value. A mutual fund may have a minimum holding period.
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About the author
Mike Zaccardi, CFA®
Mike is a freelance writer for financial advisors and investment firms. He is a CFA® charterholder and Chartered Market Technician®, and has passed the Certified Financial Planner program courses.
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