Liquid alternatives (or “alts” for short) are investment vehicles that are thought to provide diversification benefits to traditional portfolios made up of stocks and bonds. They often come in the form of exchange-traded funds (ETFs) or mutual funds. Liquid alts are directed at retail investors who cannot otherwise access areas like hedge funds and complex products meant for ultra-high-net-worth investors.
This niche group of assets features strategies that might 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 alts to their portfolios should first carefully consider their risk and return objectives. It’s 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 might first be thought of as a kind of hedge fund-like strategy, but there are many other types offered to everyday investors in today’s landscape. Available today are liquid alt investments based on macroeconomic event trading, options (puts and calls), market-neutral strategies, trend-following algorithms, long-short positioning, and nontraditional bonds.
At a high level, liquid alts are products that are not typical long-only equity or fixed-income funds. Types of assets found in liquid alt strategies include real estate, wine, art, commodities, private equity, and distressed debt.
Many of these investments are not easily bought and sold. Unlike shares of large-cap U.S. stocks, it is not as easy as clicking a button during the trading day to execute transactions. Bespoke markets exist and time-consuming bilateral deals must take place in some cases. 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 purchase alts. You simply need a brokerage account to house the ETF or mutual fund. Unlike with most hedge funds, you do not have to be an accredited investor. There still might be elevated investment minimum requirements for some mutual funds, however. With the ETF wrapper, so long as you have enough capital to purchase a single share, you can get in on the game.
Liquid alts might be particularly attractive to investors seeking to diversify their portfolios of index stock and bond funds. After all, everyone wants investments that zig when other assets zag. Investors also seek the perceived safety of some alternative areas when the stock market turns volatile. The downside is that once-winning strategies might suddenly underperform when market regimes shift.
Recall the popularity of managed futures shortly after the Great Financial Crisis—managed futures performed incredibly well relative to stocks from 2007-09, but then went on to produce mediocre returns after money poured into them. For that reason, investors must carefully weigh the risks and rewards of liquid alts so they understand the possible perils of these sometimes-complex strategies.
In What Type of Account Should an Investor Place Liquid Alts?
Before you go about putting money to work in liquid alts, you should know how they work tax-wise. In general, asset location suggests that investments with a high tax-cost ratio should go into tax-sheltered accounts like an IRA. Some investors even have access to a brokerage-linked 401(k) account within their employer’s plan. Tax-efficient assets, like low-dividend stocks, are thought better for taxable accounts since they often do not run up an individual’s tax bill.
Some liquid alts might pay out a large annual dividend or provide a significant income stream. For that reason, it could make sense to house some liquid alts in a tax-favored account.
Liquid alts are hedge-fund-like products aimed at retail investors. Their liquidity and lower costs compared to traditional hedge funds might appear appealing to investors, but high fees and sketchy long-term performance are risks to consider. Working with an experienced and knowledgeable advisor can go a long way toward ensuring liquid alts fit into a long-term financial plan.
Are Hedge Funds Liquid Alternatives?
No, hedge funds are a distinct strategy and structure. It’s common for a hedge fund to require very high investment minimums and a long commitment period from its investors. Moreover, a hedge fund usually has an additional performance-based fee. For example, the general partner of a hedge fund might charge a 2% annual fee on assets and a 20% fee on profits. A hedge fund’s holdings are not always known whereas an ETF is required to disclose its positions daily.
What Are the Fees Like?
Expect to face higher fees with a liquid alt fund versus a typical index ETF. While most liquid alt products might not have as high of a fee burden as a hedge fund, they will cost you more. Expense ratios might run upwards of 1% or more each year.
Is My Money Locked Up for a Long Time?
No, one of the upshots of liquid alternatives is that there is intra-day liquidity and no restrictions when you need to access your capital. Still, there might be high bid/ask spreads on a liquid alt ETF. Mutual funds, on the other hand, are priced once per day after the close of trading at the fund’s net asset value. A mutual fund might have a minimum holding period.
Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. Before making major financial decisions, please speak with us or another qualified professional for guidance. The original version of this article first appeared on Wealthtender written by Mike Zaccardi.