Institutional investors are beginning to take a hard look at ‘40 Act structures as alternatives to hedge fund investment. This investment vehicle is in its formative years with the most seasoned being barely five years old, yet McKinsey & Company projects inflows to approach $900 billion by year-end 2015.
A Barclays Prime Services study, Developments and Opportunities for Hedge Fund Managers, predicted a less robust $650 to $950 billion by 2018 and Citi Prime Finance offered a prediction of $939 billion by 2017. Considering the fact that liquid alternative funds total a modest $137 billion, the growth projections are stunning.
While inflow predictions vary widely, one thing seems certain; liquid alternatives are going to be increasingly competitive with hedge funds for investment dollars.
What’s in a Name
A ’40 Act fund that uses hedge-fund-like strategies is referred to by a variety of monikers: hedged mutual fund, liquid alternative, retail liquid alternative, registered alternative, registered hedge fund, retail alternative and ’40 Act alternative. However, those in the hedge fund industry tend to favor the term RIC (regulated investment company) or 40 Act Fund.
What is the Attraction?
There are four primary drivers 1) the relative transparency of liquid alternatives, 2) a substantially less expensive fee structure, 3) fewer barriers to investment for the broader retail investing public and, 4) the highly liquid nature of the investment.
Despite the obvious attractions for the retail investor, intrigued by the opportunity to engage in hedge-like investments unhindered by the need to establish credentials as a qualified investor, significant interest has also been expressed by institutional investors, with 29 percent of those surveyed indicating an interest in opening or adding to a position in liquid alternatives.
What About Performance?
Detractors of liquid alternative funds enjoy pointing out that RICs routinely under-perform hedge funds. It is true that 40 Act products managed by hedge fund managers delivered an annualized return of 1.6% over the last 6 years compared to the 2.3% return posted by the average hedge fund.
However, returns may be the least of the challenges liquid alternatives face. Many senior hedge fund managers have voiced serious concerns regarding the ability of a truly ‘hedged” liquid alternatives being in a position to raise cash quickly in the face of significant sell-offs. This concern is shared equally by the SEC which has begun investigating a number of liquid alternative funds with respect to daily liquidity, leverage and the associated risks.
Other Investor Considerations
While lower fees appeal to investors of all stripes, the question of performance remains to be answered with any degree of certainty. There just isn’t sufficient historical perspective on liquid alternatives to draw meaningful conclusions. While a few years of data may seem sufficient, one has to consider the fact that the years involved have been less than typical.
The debates will persist between hedge fund advocates and liquid alternative cheerleaders for some time to come. Future results will define the victor—not the dialogue.