Calmer waters: the Ohio River at Pittsburgh. Scarred by the rapid depreciation of assets in the financial crisis, investors are looking to diversify their approach
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Very wealthy investors increasingly are moving into the liquid alternatives market, looking to gain a piece of the traditional hedge fund and private equity action, but at a fraction of the cost and illiquidity.

Liquid alternatives (also known as “retail alternatives”) package alternative strategies such as long/short or hard-asset investing inside heavily regulated mutual funds. Advisers are leading the shift as clients search for diversification and uncorrelated returns in their portfolio.

Still scarred by the plummet of almost all assets in the 2008 financial crisis, investors are looking for less volatile, uncorrelated returns from their existing holdings. While hedge funds and private equity strategies are open to those that meet the “accredited investor” definition of having a net worth of at least $1m or who earn at least $200,000 a year, those who fall short of these requirements have previously been locked out of the alternatives market.

A survey by MainStay, a New York Life company, found high-net-worth individuals on average have one fifth of their portfolio in alternatives, with most (65 per cent) investing through mutual funds, followed by 40 per cent using exchange traded funds (ETFs) and 38 per cent managed funds.

The market has grown in recent years to hit $270bn at the end of 2013, according to Strategic Insight. The MainStay research found that financial advisers were the main way very wealthy investors discovered more about liquid alternatives.

Alternatives are being used to gain diversification and investment growth in high-net-worth investors’ portfolios, but 60 per cent are also using alternatives to protect principal capital, according to MainStay.

“Advisers and clients are looking for tools for risk management; they are looking for additional sources of returns outside of the stocks-bond-cash traditional asset matrix, and they are looking for additional diversification to build better portfolios,” says Rick Lake, portfolio manager of the Aston/Lake Partners Lasso Alternatives Fund.

As the market has seen a flood of assets, managers have responded with a flood of products. Brian Strachan, a managing director of private wealth at Morgan Stanley, says the number of liquid alternative products grew from 400 at the start of 2013 to 800 at the end of the year. That figure is expected to double again this year. “You have to really do your research to make sure you are in the right investment and asset class,” he says.

This proliferation of products means the selection process for advisers is not easy. Pedigree matters a lot, say the experts. “Liquid alternatives run by experienced hedge fund managers outperform the rest,” says Mr Lake. Academic studies support this, with a paper from London Business School finding that experienced hedge fund managers running mutual funds outperform their competitors by up to 4.1 per cent per year, net of fees.

Certain alternative strategies lend themselves better to a liquid structure than others, says Jason Katz, a managing director of private wealth at UBS Wealth Management. “Long/short equity, managed futures and global macro strategies fit better in a liquid alternative than private equity, distressed assets and fixed income arbitrage.”

While track records are scrutinised in the world of traditional investments during the selection process, they cannot always be used for liquid alternatives, says Mr Katz. “The challenge is that many of these vehicles have a fairly short lifespan of five, six or seven years at best,” he says.

Instead, one way to assess managers is to look at the record of any previous funds they ran, the experience of the portfolio managers and how long the portfolio manager has been with the asset manager.

One benefit of liquid alternatives, compared with their more illiquid counterparts, is that the fees are lower. While not as low as traditional mutual funds and ETFs, they are offered at a fraction of the cost of “true” alternatives, which typically charge a 2 per cent upfront management fee and 20 per cent of any performance generated.

However, these fees can be justified if the performance backs them up, says Mr Strachan. “The fee issue goes away based on performance – people are willing to pay for good performance,” he says. “I don’t really get a big fee objection [from clients], because it is part of a total portfolio, but as more products come into the market, lower fees are going to come,” he says.

Mr Lake predicts more mutual fund products will come from the private fund world. Hand in hand with this will be a steep learning curve for advisers to better understand the market, he says. “We will see the adviser world linking with outside resources and expertise to help navigate the world of liquid alts.”

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