Liquid alts are one of the fastest growing mutual fund sectors
"Liquid alts", or hedge funds repackaged as mutual funds, have become one of the fastest growing types of mutual funds. According to research firm Preqin, Liquid alt AUM in the US and Europe have surged to $440bn, from less than $100bn in 2008. Blackstone and Goldman Sachs are understood to manage half of all liquid alternative assets sold by big brokerage firms.
By Lauren Tara LaCapra

NEW YORK (Reuters) - John McCormick has been on a mission for the past five years: to bring hedge funds to the masses.

That may seem like a tough sell. Traditional hedge funds, those lightly regulated investment pools open exclusively to large institutions and rich individuals, have been duds lately, trailing the U.S. stock market’s performance every year since 2009 by an average of 10 percentage points, according to Hedge Fund Research Inc data.

But already, McCormick, a senior managing director at Blackstone Group LP, has been wildly successful. He has done so as a tireless evangelist for what are called liquid alternative investments, or “liquid alts.” Like hedge funds, they invest in everything from simple stocks and bonds to all sorts of complex derivatives and other “alternative” assets. The main difference is that liquid alts are packaged as mutual funds and marketed to retail investors who can’t invest in traditional hedge funds.

“Any investor who wants access to alternative strategies should have access to them,” as long as they are suitable for the investor and properly explained, McCormick said in an interview.

Apparently investors agree. Though critics complain about high fees, opaque strategies and other factors that they say make liquid alts inappropriate for small investors, these products have become one of the fastest-growing types of mutual fund.

Liquid alt assets under management in the U.S. and Europe have surged to about $440 billion, according to Preqin, a research firm specializing in alternative investments. In 2008, analysts estimate, the figure was less than $100 billion. Blackstone and its chief rival in this market, Goldman Sachs Group Inc, manage half of all liquid alternative assets sold by big brokerage firms, according to Dover Financial Research.

The appeal is not outsize returns: Liquid alts have delivered even less than hedge funds in recent years.

The reason for their popularity, McCormick said, lies in the 2008 financial crisis and the damage it inflicted on many small investors’ portfolios. “You have baby boomers nearing retirement who experienced a scary event in 2008,” he said. “People who thought they had diversification and didn’t really have it.” The long lists of assets liquid alt funds hold are designed to provide that diversification, he said.

Now, McCormick is among the scores of fund marketers pushing to get liquid alts on the menu of options for U.S. workers’ employer-sponsored, tax-deferred 401(k) retirement savings plans - a pool of money that totals $4.4 trillion. To date, these accounts have offered little-to-no exposure to alternative assets like hedge funds, private equity and real estate.

"DIFFICULT CALL"

It hasn’t been easy. The trustees who approve what’s offered in 401(k) plans have so far rejected liquid alternatives as a viable option for workers who manage their own retirement savings.

Liquid alts certainly offer diversification, said Gregg Thorsen, a Southwest Airlines Co executive who helps put together plans for $8 billion to $10 billion in employee retirement money. But, he said, “the question is really around the best way to offer the benefit of that diversification in … a retirement plan with a diverse participant base, with wide-ranging communication needs and varying education on investments.” And with the higher fees of these funds, he said, “the decision becomes an even more difficult call.”

For an idea of what goes into some of these products, consider the Columbia Adaptive Alternatives Fund, a $177 million liquid alt fund launched by Columbia Management in collaboration with Blackstone in January.

Among the assets it or its underlying funds hold: common stocks; preferred stocks; corporate bonds; foreign and domestic government bonds; bonds issued by agencies run by governments; real-estate investment trusts; exchange-traded funds; exchange-traded notes; residential and commercial mortgage-backed securities; asset-backed securities; credit-default swaps; collateralized bond obligations; collateralized loan obligations; currency swaps; futures; total return swaps; money market funds; and other liquid alternative funds, including one that in turn invests in other hedge funds.

All that diversity hasn’t yielded much to cheer about. From its launch in late January to mid-July, the Columbia Adaptive Alternatives Fund generated negative returns of about 2 percent, compared with a positive 2 percent for a Morningstar index of comparable funds and a 5 percent gain for the S&P 500 Index.

"We believe that alternative investments can complement a client's traditional equity and bond allocations by offering the potential for diversification, stability and positive expected returns over a complete market cycle," said Carlos Melville, Columbia's chief spokesman.

The fund isn’t uniquely lackluster. In the five years ended in April, alternative mutual funds in North America delivered an average annual return, after fees, of 5.8 percent, while similar funds in Europe returned 3.4 percent, both below the average 7.6 percent for hedge funds, according to Preqin. On the same basis, the S&P 500 Index returned 11.9 percent, and 14.3 percent including reinvested dividends.

For those results, investors in liquid alt funds pay a lot. Liquid alternative funds charge an annual management fee of 1.76 percent, on average, compared with 1.22 percent for actively managed mutual funds, according to Morningstar. Simple instruments, like index funds, charge annual fees that are a small fraction of 1 percent. Many liquid alternative funds also charge sales commissions that go to intermediaries like brokers.

The more complicated the fund, the higher the fees. The Columbia Adaptive Alternatives Fund, for instance, charges an initial sales fee of up to 5.75 percent and annual operating fees of 2.68 to 3.83 percent, depending on the share class. Some investors are also charged a redemption fee for selling the fund within 18 months.

PAYING THE PRICE

McCormick said higher fees reflect the added value of “a layer of professional management.” He added: “Sometimes articles are written to say liquid alts are taking advantage of retail investors because they charge such high fees. The reality is, it’s much less expensive than what you pay for hedge fund exposure.” Hedge fund managers have historically charged investors a 2 percent annual fee and taken 20 percent of investment gains.

Blackstone does not concern itself with marketing liquid alt funds directly to investors. That’s done by what McCormick calls “gatekeepers,” firms like Fidelity Investments, Morgan Stanley and Merrill Lynch that have signed marketing deals with Blackstone. It’s their job to explain the products to investors and help them decide whether the funds are a good fit.

Regulators are looking at the business to make sure that happens. The Financial Industry Regulatory Authority, an industry-funded group, and the U.S. Securities and Exchange Commission have been examining sales and marketing of liquid alts to ensure that funds are not distorting elements of their investment strategies or policies. And the SEC has been looking into funds’ disclosure of illiquid assets – which can be up to 15 percent of the fund in the United States.

One worry is that in a broad market downturn, liquid alts may not be so liquid after all. When investors rush en masse to cash out of a mutual fund, the fund’s managers have to sell assets to raise cash. But when markets are falling, unusual assets like those held in liquid alts can be hard to sell, forcing down prices even farther. That’s what happened in the financial crisis, when mortgage-backed securities, collateralized debt obligations and related derivatives were rendered virtually worthless.

The SEC plans to draft a rule or recommendation for managers of liquid alt funds on their use of derivatives, a person familiar with the matter told Reuters.

On July 15, Massachusetts Secretary of the Commonwealth William Galvin announced he was beginning an investigation into the sales practices of registered investment advisers in connection with alternative mutual funds. These funds, Galvin said, “can be accidents waiting to happen when they are sold to investors who do not understand the risks and downside associated with the product.”

Paul Jacobs, chief investment officer of Palisades Hudson Financial Group, which has $1.3 billion in assets under management, has analyzed dozens of liquid alt funds. Many of them, he said, “used a black-box strategy, meaning it’s hard to either get a good explanation of the strategy or to understand the strategy even if you do get an explanation.”

He’s found only one he thinks is worth investing in: the Merger Fund, one of the oldest liquid alternative funds, managed since 1989 by Westchester Capital Funds. Its returns – an average annual 6.6 percent since inception through Dec. 31 – “are not very sexy,” Jacobs said, but he understands what’s in it and how it will perform.

IT'S ALL ABOUT DIVERSITY

McCormick and other proponents of liquid alts say the critics are missing the point. “It’s not about promising outsized returns and getting people excited that way,” he said. “It’s about diversification” to protect against a broad, protracted downturn in financial markets.

As Goldman Sachs Asset Management says on its website: “Elevated stock market valuations and the prospect of rising interest rates may mean lower returns in traditional portfolios. However, alternative investments have historically delivered attractive relative rates of return in challenging equity and fixed income environments.”

It’s hard to put that to the test, though, since most liquid alt funds available today were launched since the current bull market began in March 2009. Ultimately, McCormick and other liquid alt proponents argue, it’s up to the investor to decide whether the benefits of the funds are worth the fees and risks.

A graduate of Vassar College and Yale Law School, McCormick worked as a McKinsey & Co consultant and a corporate lawyer before he joined Blackstone in 2005. Now 47-years-old, he credits much of his success in building Blackstone’s liquid alts business to teamwork with colleague Brett Condron, 38, who joined Blackstone from Putnam Investments in 2010, as well as others at the firm who green-lighted his endeavor and helped create the guts of the products.

Together, they were able to persuade hedge fund managers to develop liquid alts with Blackstone and sign up brokers to sell them.

The financial crisis made the job easier. Until then, premier hedge fund managers tended to shun retail investors. During and after the crisis, hedge fund performance flagged, big investors started pulling back, and fee income shrank. McCormick was then able to convince big name firms like Two Sigma Investments and Wellington Management that it was worthwhile to manage money for Main Street.

“The investor base for hedge funds has continued to evolve, and individual investors could represent the next big wave of demand,” said Nobel Gulati, chief executive officer at Two Sigma Advisers LLC, part of the firm that manages money for institutional investors.

With established fund managers on board, it was easier to get big brokerage and financial services firms to market the funds. Executives at outfits like Morgan Stanley, Merrill Lynch and Fidelity knew that many retail investors wanted to get into hedge funds but couldn’t because they either didn’t qualify as accredited investors under SEC rules or couldn’t afford the large minimum investments. Liquid alts would meet that demand. By and large, sales forces need little convincing beyond the prospect of a sales commission.

The next goal – getting the funds into retirement savings plans – is a challenge, and not just because of subpar performance and high fees. Plan sponsors are held to a much higher standard than financial advisers. This so-called fiduciary standard means they must ensure that products offered are truly in investors' best interests.

Matt Smith, who manages the Bank of Montreal’s retirement-services business, noted that many fiduciaries want to see a three-year track record, but most liquid alt funds haven’t been around that long.

He said plan sponsors might be open to including liquid alts as part of a portfolio – say, packaged into a target-date fund. But they are wary of offering them as standalone options in which workers who aren’t financially sophisticated can put all their money.

McCormick counters that most institutional investors, including some pension funds, own far more alternative assets than individual investors do.

Still, McCormick's boss, Tom Hill, who runs alternatives at Blackstone, said at the company’s investor day last year that the firm faces significant “hurdles” to getting liquid alternatives into 401(k) plans. Blackstone, he said, hadn’t “cracked the code yet.”

(Edited by Dan Wilchins and John Blanton)