Key Takeaways
- • Morningstar's Ben Johnson-style analysis (author is a Morningstar columnist) concludes that liquid alternatives funds belong on most investors' "too hard" pile, citing weak evidence that they improve diversified portfolios.
- • In an August 2018 Morningstar analysis by Jason Kephart and Maciej Kowara, only 8 of 134 funds (6%) improved a 60/40 portfolio's Sharpe ratio by more than 10% over the five years through 2017.
- • Over the October 2007 to March 2012 period, 17 of 65 funds (26%) improved the 60/40 portfolio's Sharpe ratio by more than 10%, according to the follow-up study.
- • Investors poured $33.4 billion into liquid alternatives funds in 2021, the most since 2013, even as the category shows high attrition: 56% of the 797 funds that have belonged to the broad alternative Morningstar Category have been liquidated or merged.
- • Average asset-weighted fees for actively managed alternative funds were 1.20% in 2020, nearly double the 0.62% for all actively managed funds.
Summary
Markets have sold off in early 2022. The Morningstar Global Stock Market Index fell 5.5% in the first quarter, and the Morningstar U.S. Core Bond Index dropped a further 6% through March after a 1.6% loss in 2021, its first calendar-year decline since 2013. Against that backdrop, investors allocated $33.4 billion to liquid alternatives funds in 2021, the largest annual inflow since 2013, according to Morningstar.
Liquid alternatives funds emerged after the global financial crisis, offering mutual fund versions of strategies previously confined to hedge funds. They span arbitrage, long-short equity, equity market-neutral, and trend-following approaches, with the stated aim of improving risk-adjusted returns relative to traditional stock and bond portfolios.
Morningstar's test of that claim is mixed to poor. In an August 2018 analysis, Jason Kephart and Maciej Kowara benchmarked each fund against a 60% stock/40% bond index portfolio, allocating to each fund to maximize Sharpe ratio. Over 2013 to 2017, most surviving funds failed to improve the benchmark's Sharpe ratio, and only 8 of 134 funds did so by more than 10%. Including merged and closed funds would have worsened the results. A follow-up covering October 2007 to March 2012 found a smaller sample of 65 funds, of which 17 (26%) improved the benchmark's Sharpe ratio by more than 10%.
The article, written by a Morningstar columnist, cites Morningstar's 2021 Global Liquid Alternatives Landscape to outline ten challenges, including high fund churn, liquidity mismatches, leverage, personnel instability, and fees. Only about 10% of funds as of June 2021 had survived the 2008 crisis, and the median age of expired funds was four years. Investors have also lagged fund returns, buying after strong performance and selling near lows, per dollar-weighted versus time-weighted return comparisons over the 10 years through December 31, 2020.
The author concludes that liquid alternatives belong on most investors' "too hard" pile, while acknowledging a handful of standouts. Investing enough capital to capture diversification benefits and holding through long periods of underperformance would be difficult for most investors.
Liquid alternatives funds emerged after the global financial crisis, offering mutual fund versions of strategies previously confined to hedge funds. They span arbitrage, long-short equity, equity market-neutral, and trend-following approaches, with the stated aim of improving risk-adjusted returns relative to traditional stock and bond portfolios.
Morningstar's test of that claim is mixed to poor. In an August 2018 analysis, Jason Kephart and Maciej Kowara benchmarked each fund against a 60% stock/40% bond index portfolio, allocating to each fund to maximize Sharpe ratio. Over 2013 to 2017, most surviving funds failed to improve the benchmark's Sharpe ratio, and only 8 of 134 funds did so by more than 10%. Including merged and closed funds would have worsened the results. A follow-up covering October 2007 to March 2012 found a smaller sample of 65 funds, of which 17 (26%) improved the benchmark's Sharpe ratio by more than 10%.
The article, written by a Morningstar columnist, cites Morningstar's 2021 Global Liquid Alternatives Landscape to outline ten challenges, including high fund churn, liquidity mismatches, leverage, personnel instability, and fees. Only about 10% of funds as of June 2021 had survived the 2008 crisis, and the median age of expired funds was four years. Investors have also lagged fund returns, buying after strong performance and selling near lows, per dollar-weighted versus time-weighted return comparisons over the 10 years through December 31, 2020.
The author concludes that liquid alternatives belong on most investors' "too hard" pile, while acknowledging a handful of standouts. Investing enough capital to capture diversification benefits and holding through long periods of underperformance would be difficult for most investors.
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