[JP] The use of convertible bonds in the asset allocation process
will the real alternatives please stand up
1. Pearl Capital Advisors, LLC
505 Montgomery, Suite 1143, San Francisco, CA 94111
Phone: 650.278.2032
Will the real alternatives please stand up?
This report is a review of liquid alternative investments (“Liquid Alt(s)”) and how their
performance fares against common, widely held views regarding their diversification
benefits and properties. We explore whether or not adding Liquid Alt products to your
overall portfolio will improve the portfolio’s risk-adjusted returns.
Authors
Timothy R. Jacobson, CFA
Managing Partner
jacobson@pearlcapitaladvisors.com
Lawson E. Stringer
Managing Partner
stringer@pearlcapitaladvisors.com
November 2014
2. 1
Introduction
Traditionally, a typical advisor may build for a client a portfolio that closely resembles the following
profile: 55% stock, 35% bonds and 10% real-estate. However, one profile which historically has only been
accessible to the wealthiest individuals, is one which includes alternative investments—more commonly
known as hedge funds. Access to these alternative investments is now changing due to the relativity new
introduction of liquid alternatives (“Liquid Alt(s)”).
Liquid Alts is a term used for mutual funds and exchange-traded funds (“ETFs”) that use ‘hedge-fund-
like’ strategies that are more sophisticated than conventional buy-and-hold strategies. Liquid Alt
strategies are meant to reduce portfolio risk and provide absolute returns—meaning that they should
perform positively under most market conditions. A significant difference between a hedge fund and a
Liquid Alt product is that a Liquid Alt product has more regulatory oversight. This oversight may
include requiring daily liquidity and pricing as well as limitations on the types of instruments allowed
and the use of leverage. Many investment professionals see that Liquid Alts provide the historic strengths
of hedge funds while benefiting from the regulatory oversight of mutual funds.
Recently, there has been prolific growth in the amount of alternative investment products offered and
wrapped in mutual fund and ETF structures. Strategies far ranging from equity long/short, event driven,
merger arbitrage, global macro, and managed futures are a few such offerings. It is generally understood
that Liquid Alts should occupy a core holding within investor portfolios due to their anticipated lower
volatility and non-correlated returns in both rising and falling markets.
The Liquid Alt offering seems like a big win for the small investor: access to investment strategies once
only available to the wealthy few and now easily accessible through mutual fund and ETF structures.
This report displays the results of a materially comprehensive analysis of Liquid Alts, debunks many of
the reasons given to advisors and investors to add these products into their portfolios, and lays out the
“call to action” advisors and investors should take when seeking genuine exposure to the hedge fund
alternative asset class. Our research strongly suggests Liquid Alts are not the boon to investors they
purport to be.
The Approach
To conduct a broad and, in our opinion, fair evaluation of the performance of Liquid Alts, we selected
from the Multialternative class of Liquid Alts. These products should demonstrate the diversifying
properties of Liquid Alts hoped for by advisors and investors. After analyzing the 25 largest
Multialternative Liquid Alt funds, we present the impact these funds have on a Generic Portfolio (defined
in Appendix I - Methodology).
3. 2
The Analysis
This analysis takes the largest 25 Liquid Alternative multi-alternative mutual funds (“Liquid Alt(s)”) with
track records dating back to December 31, 2010. A subset of the 25 funds was also formed, consisting of
14 Liquid Alts with track records dating back to December 31, 2007 (see Appendix I - Analysis Universe).
A Generic Portfolio was created using ETFs to mimic a 55/35/10 stock, bond, real-estate portfolio. Each
Liquid Alt fund was combined with the Generic Portfolio (see Appendix I - Analysis Universe) in turn to
form a combined portfolio. Twenty-five combined portfolios were created from the larger group of funds
and 14 combined portfolios were created from the subset group. Each of the 25 combined portfolios was
created dating from December 31, 2010 to September 30, 2014. Each of the 14 combined portfolios was
created dating from December 31, 2007 to September 30, 2014.
The summary Sharpe and RoMAD (Return over Maximum Drawdown) ratios of each combined portfolio
are compared to those of the stand-alone Generic Portfolio. In addition to the comparison of Sharpe and
RoMAD ratios for the subset of 14 funds, the maximum drawdowns of each combined portfolio are
added to the analysis to evaluate each Liquid Alt fund’s diversification and capital protection properties
during the 2008 financial crisis. The results are as follows:
In Charts 1 and 2, the Sharpe and RoMAD ratios for each of the 25 combined portfolios are shown. The
results show, since December 31, 2010, the large majority (20 of 25 or 80%) of Liquid Alt products, when
combined with the Generic Portfolio, do not improve the Generic Portfolio’s stand-alone performance as
measured by Sharpe and RoMAD ratios.
Chart 1: Sharpe Ratio (Jan 2011 to Sep 2014) Chart 2: RoMAD Ratio (Jan 2011 to Sep 2014)
In actuality, 80% of these Liquid Alt funds had a negative impact (lowered Sharpe and RoMAD ratios) on
the Generic Portfolio. Investors would have experienced higher Sharpe and RoMAD ratios had they only
invested in the Generic Portfolio and excluded Liquid Alts from their portfolios.
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RDRAX
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SharpeGeneric Portfolio
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RoMADGeneric Portfolio
4. 3
To anticipate the rebuttal that the date range from 2011 to present is not a meaningful market cycle
segment to measure the Liquid Alt group’s ability to improve risk-adjusted returns, a subset of these
Liquid Alt funds with longer track records was also measured. The date range was extended to include
the period between December 31, 2007 and September 30, 2014 and 14 of the 25 funds met this new
criterion. Again, the large majority (12 of 14 or 86%) of Liquid Alt funds failed to improve the Generic
Portfolio’s performance as measured by Sharpe and RoMAD ratios. See the 14 combined portfolio Sharpe
and RoMAD ratios in Charts 3 and 4 below.
Chart 3: Sharpe Ratio (Jan 2008 to Sep 2014) Chart 4: RoMAD Ratio (Jan 2008 to Sep 2014)
Furthermore, the Liquid Alt products failed to provide diversification and capital protection during the
very period (i.e. 2008) in which they were supposed to perform. All but three funds had drawdowns of
25% or more and four of the funds had drawdowns which met or exceeded that of the Generic Portfolio (-
34.16%). See Charts 5 below.
Chart 5: Maximum Drawdown
(Jan 2008 to Sep 2014)
Both in terms of diversification (i.e. improving Sharpe and RoMAD ratio) and capital preservation (i.e.
limiting drawdowns), the Liquid Alt Multialternative group has failed to deliver. While some may argue
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SharpeGeneric Portfolio
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5. 4
the failure to perform is more symptomatic of the times, the fact remains that even in the short time they
have existed, they have already failed to deliver on their promise. Given this performance has happened
“out-of-the-gate” places serious doubt the group can or will deliver their anticipated performance in the
future.
Furthermore, investors paid on average 2.03% (weighted average based on assets) to these Liquid Alt
funds. By including these funds with the Generic Portfolio, the annual blended cost of each combined
portfolio rises from 0.08% per year to 0.28% per year—in return for a reduction in risk-adjusted returns.
The expense for each individual fund is shown in Chart 6 while the blended fee structure for each
combined portfolio can be seen below in Chart 7.
Chart 6: Liquid Alt Expense as a % of AUM Chart 7: Blended Expense as a % of AUM
The above data make it clear—Liquid Alts have failed and will likely continue to fail investors and their
advisors. Historically they have largely not improved performance, as measured either by Sharpe or
RoMAD ratios. Putting it plainly, these are not the real alternatives.
Better Than Hedge Funds?
The body of research supporting that investors may benefit from including alternatives, namely hedge
funds, in their portfolios is too exhaustive to single out a single paper. We write this paper under the
assumption that alternative investments do improve intuitional portfolios. However, some have argued
(Towle and Sundt) that Liquid Alts at least perform better than hedge funds. To make their argument,
they compare the Liquid Alt universe with the broad HFRI Indices. This is unequivocally an apples-to-
oranges comparison. Implicit in the Liquid Alt products is a selection bias. Only the best available
alternative strategies and managers, which can or are housed within mutual fund and ETF structures, are
selected for Liquid Alt products, whereas the HFRI Indices take no view on which strategies and
managers are “good” or “bad.” Liquid Alts are constructed with the benefit of hind-sight while the HFRI
Indices are just a compilation of reported strategies and take no view on quality. Therefore, one cannot
argue that Liquid Alts have outperformed hedge funds. In fact, many managers who offer both hedge
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ExpenseGeneric Portfolio
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Blended ExpenseGeneric Portfolio
6. 5
fund and mutual fund versions of their strategy deliberately differentiate the two versions of their
strategy; a student of alternative strategies would easily know this is the case.
Poorly Structured
Why Liquid Alts destroy value (lower risk-adjusted returns) is, in large part, due to the governance of
Liquid Alts by the Investment Company Act of 1940 (“1940 Act”). Additionally, the 1940 Act restricts the
amount of short-selling and oft times many hedge fund strategies use short-selling either as a hedge or in
some speculative measure to capture some unique opportunities; this is especially the case in arbitrage,
relative value, and market neutral strategies. Having this restriction greatly reduces the opportunities
and ultimately changes the profile of the strategy.
Also of concern is the restriction on futures. Products managed according to the 1940 Act can only have
limited amount of exposure to futures. Many alternative strategies are futures-based and offer attractive
and uncorrelated returns. However, because of the restriction on futures, many of the futures-based
strategies are not accessible directly. Generally, a counterparty is introduced through which synthetic
SWAP and derivative exposure to these strategies is obtained. These SWAPs and derivatives complicate
the process and introduce new forms of illiquidity, costs, and most significantly, risks to investors. Rather
than accessing these strategies directly, investors must now take on counterparty risk which violates
Liquid Alts’ paramount values of liquidity and transparency.
Not only do Liquid Alts rely on SWAPs and derivatives as a round-about solution to overcome
restrictions on the use of futures, but also to bypass limits on the use of leverage. These workarounds are
becoming a concern of the Office of Compliance Inspections and Examinations (OCIE) of the SEC and has
been a key focus of its examination priorities for 2014. Turning to counterparty SWAPs and derivatives
for leverage inherently reduces transparency, and again increases risk and is, quite frankly, hypocritical
of an industry calling itself Liquid Alt. Additionally, the fact the SEC is still grappling with how to
regulate Liquid Alts exposes investors to new regulatory risks that could change the rules of investing
mid-stream and could leave investors stranded.
Furthermore, the restriction on leverage of Liquid Alts on the surface may seem like a protection for
investors. However, this restriction on leverage can and does inherently change the return profile of
Liquid Alts compared to their hedge fund predecessors. The leverage restriction limits how trades and
opportunities can be exploited by Liquid Alt managers and alters how returns can be engineered or
structured. As a result of these restrictions, the Liquid Alt strategy cannot deliver the same return profile.
For this reason, Liquid Alt product engineers turned to counterparty SWAPs and derivatives to hide the
actual leverage used.
The introduction of Liquid Alts to the market place and the exponential growth over the last few years
has been attributed to unintentional consequences of the Dodd-Frank Act. Many hedge fund managers
became SEC-registered and sought other revenue streams for their hedge fund products. The length of
7. 6
time Liquid Alts have been offered may be a relatively short period of time, but investors and their
advisors should be asking themselves what makes a good alternative investment. Based on our findings,
there is little to no value found among the Liquid Alts. If you are seriously considering an alternative
investment, investors should perform their due-diligence and not simply add a Liquid Alt to a portfolio
because it is exchange-traded or doesn’t require a K1 for tax purposes.
Conclusion
Investors and their advisors should be particularly wary of allocating any amount of capital to Liquid
Alts. In its short history, the group has already failed to deliver diversification (i.e. higher Sharpe or
RoMAD ratios) or capital preservation (i.e. limiting drawdowns). The regulations governing mutual
funds, at best, dilute the intended return profile and, at worst, actually increase the risks through
masking actual exposures and leverage behind SWAPs and derivatives which are laden with
counterparty risk and which are not necessary in the conventional hedge fund space.
The regulatory landscape for these Liquid Alt products is murky and the SEC is playing catch-up—
exposing investors to regulatory risk. Given how these Liquid Alt products have failed to perform and
given known regulatory constraints and unknown regulatory risks, we claim the value for Liquid Alts
just isn’t there.
There are many hedge funds that have now increased their own transparency and lowered liquidity
requirements to meet consumer demand. Don’t be fooled by the masqueraders. If you are seriously
considering alternatives as part of your portfolio, ask: "Will the real alternatives please stand up?"
8. 7
Appendix I
Methodology
The Generic Portfolio is intended to mimic a portfolio that an advisor might construct for his or her client.
The Generic Portfolio is a mixture of 55% stocks, 35% bonds, and 10% real-estate, as represented by three
ETFs: IVV, AGG, and VNQ, respectively.
Each Generic Portfolio is combined with each Liquid Alt fund in turn by reducing each of the holdings by
10% and adding the remaining exposure to that Liquid Alt fund. The resulting exposures are 49.5% IVV,
31.5% AGG, 9.0% VNQ, and 10% Liquid Alt1, 2, 3…n fund. A combined portfolio is build with each Liquid
Alt fund in turn. The results of each combined portfolio are compared to the stand-alone Generic
Portfolio.
Analysis Universe
The Liquid Alt funds used in this analysis are the largest 25 mutual funds (including one ETF), with a
track record starting after December 31, 2010, and is classed in the industry as a Multialternative. These
25 funds represent $17.8 billion in assets under management and roughly 39% of the Multialternative
group’s assets. Fourteen of these funds with track records dating back to at least December 31, 2007 form
a subset to further analyze the group’s capability to fulfill the investment objective to provide
diversification and to protect capital. The group’s subset represents $8.3 billion in assets under
management and approximately 18% of the Multialternative group’s assets. The tickers of these funds are
listed below.
Group I
(12/31/2010 – 9/30/2014)
Group I Subset
(12/31/2007 – 9/30/2014)
GAFAX
ASFAX ASFAX
GARTX
JAAAX
VPDAX VPDAX
QAI
QOPBX QOPBX
PASIX PASIX
ALPHX ALPHX
AAAAX AAAAX
SELAX
ALSNX
IMUAX IMUAX
AVGAX AVGAX
SMSAX
DVRAX DVRAX
DRRAX
BNAAX BNAAX
10. 9
References:
1. “The Case for Liquid Alternative Investments.” Jon Sundt and Allen Cheng, June 2012.
http://www.altegris.com/~/media/Files/White%20Paper/ALT_LiqAlts_WhitePaper_Single.pdf
2. “Liquid Alternative Investments versus Hedge Funds: A Quantitative Analysis.” Margaret M.
Towle, PhD, CPWA and Dylan Thomas Jones, March 2013.
http://www.alphacapitalmgmt.com/media/pdfs/IWM13MarApr_LiquidAItsVsHedgeFunds.pdf
3. Morningstar.com
4. “Examination Priorities for 2014.” U.S. Securities and Exchange Commission, Office of
Compliance Inspections and Examinations, January 9, 2014.
http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf
5. “SEC Adopts Dodd-Frank Act Amendments to Investment Advisers Act.” U.S. Securities and
Exchange Commission, June 22, 2011.
http://www.sec.gov/news/press/2011/2011-133.htm
6. “Madoff's Revenge: The Rise Of Liquid Alternatives.” O'Brien Greene & Co., June 2014.
http://seekingalpha.com/article/2268063-madoffs-revenge-the-rise-of-liquid-alternatives
