Key Takeaways
- • Liquid alternative funds have lagged badly over the past five years, with nearly all Morningstar alternative categories trailing a 60/40 portfolio and all but one category average behind high-quality U.S. bonds, according to the author Ben Carlson.
- • The author attributes the underperformance to four structural factors: low interest rates eroding cash-collateral returns, the value factor's decade-long underperformance versus growth, increased competition from easier retail access, and fees that remain well above index funds.
- • The author argues the core reasons investors use alternatives (diversification, low rates, elevated valuations) have not changed, but liquid alts in ETF form address hedge fund problems of high fees, illiquidity, and opacity.
- • The piece promotes the Wealth/Stack Conference in Scottsdale, AZ, featuring panelists from JP Morgan, GraniteShares, AQR Capital Management, and CLS Investments.
Summary
A reporter's question about the weak performance of long/short mutual funds prompted this commentary on liquid alternatives. Readers have been drawn to hedged products for their potential to reduce volatility in the current market, yet the category has struggled. The author notes that nearly every liquid alternatives category has had a difficult run. Over five years, Morningstar's alternative fund universe has badly lagged the S&P 500, a result the author says is unsurprising given that non-correlated strategies struggle during a strong bull market. More concerning, the alternatives categories have also trailed a 60/40 portfolio and, with one exception, have lagged high-quality U.S. bonds.
The author identifies several explanations. First, low interest rates matter because alternative strategies are essentially cash-plus return streams. Short-selling funds borrow shares, pay a borrow rate to prime brokers, and hold proceeds in cash equivalents; as recently as the mid-2000s that cash earned 5-6%, a yield no longer available. Second, many alternative strategies are factor-based, most often on value, which has been overwhelmed by growth over the past decade. Third, access to these strategies has broadened over the past 10-15 years, increasing competition. Fourth, while liquid alt fees are lower than the traditional 2-and-20 hedge fund model, they remain far above index fund costs, creating a hurdle that combines with low rates to weigh on returns.
The author maintains that the underlying rationale for alternatives remains intact, citing diversification benefits, low interest rates, and above-average valuations. He cautions that alternatives are more complex than traditional asset classes and require investor education before allocation. He frames liquid alts in ETF structures as an improvement over hedge funds, which he associates with high fees, illiquidity, limited transparency, and lengthy legal documentation. The commentary closes by promoting the Wealth/Stack Conference in Scottsdale, AZ, where a panel including Yasmin Dahya (JP Morgan), Will Rhind (GraniteShares), Dan Villalon (AQR Capital Management), and Shana Sissel (CLS Investments) will discuss alternatives.
The author identifies several explanations. First, low interest rates matter because alternative strategies are essentially cash-plus return streams. Short-selling funds borrow shares, pay a borrow rate to prime brokers, and hold proceeds in cash equivalents; as recently as the mid-2000s that cash earned 5-6%, a yield no longer available. Second, many alternative strategies are factor-based, most often on value, which has been overwhelmed by growth over the past decade. Third, access to these strategies has broadened over the past 10-15 years, increasing competition. Fourth, while liquid alt fees are lower than the traditional 2-and-20 hedge fund model, they remain far above index fund costs, creating a hurdle that combines with low rates to weigh on returns.
The author maintains that the underlying rationale for alternatives remains intact, citing diversification benefits, low interest rates, and above-average valuations. He cautions that alternatives are more complex than traditional asset classes and require investor education before allocation. He frames liquid alts in ETF structures as an improvement over hedge funds, which he associates with high fees, illiquidity, limited transparency, and lengthy legal documentation. The commentary closes by promoting the Wealth/Stack Conference in Scottsdale, AZ, where a panel including Yasmin Dahya (JP Morgan), Will Rhind (GraniteShares), Dan Villalon (AQR Capital Management), and Shana Sissel (CLS Investments) will discuss alternatives.
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