What it means
Alternative investments are those that go beyond plain shares and bonds. Traditional versions, such as hedge funds and private equity, are usually open to wealthy investors, have high minimums and tie money up for long periods.
Liquid alternatives package similar strategies in regulated funds that can be bought and sold on a daily basis. A long-short fund, for example, buys shares it expects to rise and sells short shares it expects to fall, aiming to earn returns that do not depend on the whole market going up.
The attraction is diversification. Because these strategies can behave differently from shares and bonds, they may reduce the swings in a portfolio, though that is not guaranteed.
Advisers often use them as a small part of a portfolio to spread risk, and some investors use them as a partial substitute for bonds when yields are low. The trade-offs matter.
Regulated funds face limits on borrowing, short selling and holding illiquid assets, so liquid alternatives cannot always replicate what a hedge fund does. Fees are often higher than for plain index funds, and in a market crash some strategies have fallen alongside shares, disappointing investors who expected protection.
Finance professionals should look carefully at what a fund actually does, how it earns its returns and what it costs. The label is broad, covering strategies with very different risks, so two funds with the same name can behave in very different ways.
A helpful check is to look at how the fund performed in past market falls and how closely its returns have moved with an ordinary share index. If the link is close, the fund may add cost without adding much diversification.
In practice
Real-world examples.
Example
A financial adviser allocates 10% of a client's $500,000 portfolio to a market-neutral fund. The $50,000 position is meant to reduce the portfolio's swings when shares fall. The adviser explains that the fund may lag in strong rising markets, which is the price of the smoother ride.
Example
A pension fund trustee considers a managed futures fund that can profit from both rising and falling markets. She compares its fees and past returns in different market conditions with those of a traditional bond fund. She decides to start with a small allocation and review it after a year.
Example
A small business owner invests spare cash in a liquid alternatives fund through an online platform. The fund can be sold at the end of any trading day, unlike a hedge fund that might restrict withdrawals. The owner still keeps an emergency cash reserve outside the fund, since the value can fall.
Formula
Calculation
Net return = gross return - total fund expenses. Annual cost in dollars = investment x expense ratio.
Suppose an investor places $200,000 in a liquid alternatives fund whose strategy earns a gross return of 6.5% before costs, and the fund charges total expenses of 1.8%. Net return = 6.5% - 1.8% = 4.7%. The investor's gain = 200,000 x 0.047 = $9,400. Costs in dollars = 200,000 x 0.018 = $3,600, so more than a quarter of the gross return, 1.8 / 6.5 = about 28%, goes to fees.Case study
Seen in the real world.
Fairhaven Advisers is an illustrative, fictional firm that added a liquid alternatives fund to its client portfolios after a period of volatile markets. The fund used a long-short strategy and charged an annual expense ratio of 1.5%.
In the following year shares fell by 12% and the fund lost 4%, which was less than the market but not the gain some clients had hoped for. The firm explained that the aim was to reduce the size of the fall, not to make a profit.
In this illustrative case, the firm reviewed the holding annually, comparing its results and fees with simple alternatives such as holding more cash or short-term bonds. It kept the fund for clients who valued smoother returns but reduced the allocation for clients focused on keeping costs low. The review notes were shared with clients in plain language.
Watch out
Common mistakes.
- Assuming liquid alternatives behave like hedge funds, when regulated fund rules limit the leverage and illiquid investments they can use.
- Expecting protection in every downturn, when some strategies fall with the market.
- Ignoring fees, which can take a large share of the return from a strategy that targets modest gains and leave little for the investor once all costs are counted.
Questions
People also ask.
What makes them liquid?
They are structured as mutual funds or exchange-traded funds, which normally allow investors to buy and sell on any trading day.
Who should consider them?
Investors who want diversification and understand the strategy, usually as a small part of a diversified portfolio, and who are prepared to accept returns that may differ from the stock market for long periods.
Are they safer than shares?
Not necessarily, because the risks depend on the strategy, and some use short selling or derivatives that can lose money in unexpected ways.
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