“Liquid alternatives” have been the growth story for the U.S. mutual fund industry this year. Through the end of June, the alternative fund category reached $156 billion in total assets and a one-year organic AUM growth rate of 30.3%, according to Morningstar. In contrast, U.S. equity funds grew AUM by 1%; taxable bond funds declined by 0.6% over the same period.
In the first half of 2014, hedge funds also enjoyed strong growth, with AUM rising to a record $2.35 trillion at the end of the second quarter. The hedge fund industry captured $57 billion in net cash flow through the first six months of this year, according to Hedge Fund Research.
Assets are flooding into both liquid alternatives (alternative mutual funds) and hedge funds, but there is another story swirling beneath the surface. Just as ETFs have become serious competition for index mutual funds, liquid alternatives are starting to rival hedge funds.
Leading hedge fund indexes have been in a performance funk since 2007, and this year is no exception. Year-to-date through August, the HFRI Fund Weighted Composite Index returned 2.43%, compared to 8.39% for the S&P 500. Over the same period, Morningstar’s largest alternative category, Long/Short Equity, returned 3.52%.
For financial advisors and their clients, liquid alternatives have several clear advantages over hedge funds: lower costs, daily valuation, liquidity, transparency and simple tax reporting. If liquid alternatives also can achieve long-term performance that is better than hedge funds, the competitive balance could tip dramatically in their favor. For reasons explained here, I believe this could happen.
Teeing up the Performance Comparison
A performance comparison between liquid alternatives and hedge funds is not simple or apples-to-apples.
- The hedge fund industry has been around for decades, while relatively few liquid alternatives have track records more than 10 years long. However, individual hedge funds come and go for a variety of reasons. Individual mutual funds have more staying power, on the whole.
- Hedge funds can use virtually unlimited leverage and hold a large part of their portfolios in “illiquid securities” – those that take more than one day to liquidate in public markets. Mutual funds are limited to: 1) leverage not exceeding 33% of gross asset value; and 2) illiquid holdings not exceeding 15% of assets.
- Leading hedge fund indexes, such as those published by HFR and Credit Suisse, contain an upside “survivorship bias” because poor-performing funds tend to drop out of the indexes over time. Studies have estimated that survivorship bias adds about 1.5% to 2% of annualized return to actual hedge fund performance. Survivorship bias is believed to be a negligible factor in alternative mutual funds.
Keeping these factors in mind, here is the 1-year, 3-year and 5-year performance for Morningstar’s three largest alternative categories, compared to the most comparable HFRI categories, as of the end of August.
|Mstar Long/Short Equity||10.47%||8.72%||8.23%|
|HFRI Equity Hedge||8.93%||4.53%||6.46%|
|HFRI Fund of Funds Composite Index||5.85%||2.94%||3.79%|
|Mstar Market Neutral||2.79%||1.29%||1.30%|
|HFRI Equity Market Neutral||4.25%||2.5%||2.52%|
- Long/short mutual funds have consistently outperformed their counterpart hedge fund category over all periods. The outperformance would be even greater if survivorship bias were considered.
- Multi-alternative mutual funds have trailed their hedge fund counterparts over all periods, by an amount exceeding a reasonable allowance for survivorship bias.
- Market neutral mutual funds have trailed their hedge fund counterparts over all periods, but the difference is within a reasonable allowance for survivorship bias.
Although this is perhaps the best apples-to-apples comparison currently available, financial advisors should be aware of other views. The hedge fund industry is confronting liquid alternative competition with its own analyses, some of which focus on a theory that mutual fund investors suffer a “liquidity discount” in performance compared to hedge funds.
The Liquidity Discount Argument
The idea behind a “liquidity discount” seems simple, on the surface. Suppose you have a choice between two managers who pursue similar alternative styles except for differences required by structure:
- Manager A works in a hedge fund, with the freedom to participate in illiquid investments.
- Manager B works in a mutual fund structure and must stick to liquid investments to meet regulatory requirements and daily redemption requests.
The liquidity-discount theory says that if you choose Manager B, you will pay a price over time in net (after-cost) performance, and it can be as high as 1-2% annually.
Bear in mind that the cost factors in this analysis go beyond liquidity, as expressed in this formula:
Mutual fund expense advantage – cost of liquidity = Liquidity premium (discount)
If mutual fund clients realize more fee/expense advantage (over hedge funds) than they are giving up as a cost of liquidity, they enjoy a liquidity premium, not a discount. Intuitively, many financial advisors believe the result of this equation is positive; i.e., alternative mutual funds do provide a liquidity premium over time. The five-year outperformance of Morningstar’s Long/Short Equity category over HFRI’s Equity Hedged category also supports this view. However, let’s dig into the case for a liquidity discount to evaluate it further.
The Case for a Liquidity Discount
For several decades, academic researchers have looked at the hedge fund universe and concluded that it shows a modest internal liquidity premium, in most market environments. In other words, hedge funds with the highest barriers to redemptions generally have outperformed those that enable more liberal redemptions. During the market crisis of 2008, this premium dried up as hedge funds faced unprecedented redemptions and were forced to sell illiquid securities into thin markets.
In 2013, Cliffwater LLC published a research report that aimed to measure the performance of private alternative funds (e.g., hedge funds) vs. liquid alternatives. The title and link to the PDF file are below.
Performance of Private versus Liquid Alternatives: How Big a Difference? https://www.cliffwater.com/documents/1181513
Cliffwater documented performance of 148 pairs of investments over the past 10 years (ending 3/13/14). Each pair consisted of one private hedge fund and a liquid alternative with a similar style, measured over the same period. Since very few liquid alternative funds have a 10-year track record, most pairs were compared over shorter periods. Cliffwater documented that for all 148 pairs, the average annualized performance difference was 0.98%. It then concluded that this is approximately the net (after-cost) performance discount that mutual fund investors pay annually for their redemption privilege.
In 2014, Morgan Stanley added to the debate in a report from its Global Investment Committee (GIC) entitled An Outcomes-Oriented Approach to Alternatives. www2.morganstanley.com/wealth/investmentstrategies/pdfs/gic_approachtoalternatives_0214.pdf
This report argued for the presence of a liquidity discount in alternative mutual funds by evaluating only one year of performance data, 2013.
Both Cliffwater and Morgan Stanley used subjectively selective (and admittedly inconclusive) analytical methods, and some comparisons made by hedge fund promoters are even more subjective. For example, check out the cherry-picking used by Crystal Capital Partners to support their sweeping claim that “…most institutional-quality hedge funds have consistently earned above average rates of return that exceed those of liquid alternatives.” www.crystalfunds.com/ctng/docs/StrategyPaper/LiquidAlts.pdf
Interestingly, none of the analysis that supports the case for a liquidity discount cites the most direct comparison – Morningstar Long/Short Equity vs. HFRI Equity Hedge over the past five years.
Long/Short Equity is the largest category of alternative mutual funds, with $60 billion of assets. Two dozen Long/Short Equity mutual funds now have track records of at least five years.
Key Questions for Advisors
The focus on comparing long-term alternative mutual fund vs. hedge fund performance has raised important questions for advisors to consider:
- What do hedge funds really cost? Morningstar offers detailed data on what mutual funds cost, by category. But after decades of hedge fund history, there is still little reliable data on what hedge funds actually cost on an all-in basis over time. Yet, costs are an important factor in any liquidity discount (premium) analysis.
- Do more talented managers work for hedge funds? If hedge funds have demonstrated historic outperformance vs. alternative mutual funds, it could have less to do with liquidity than the fact that hedge funds traditionally have paid higher compensation to attract top managers. However, as more top hedge fund managers join liquid alternatives, the talent gap may be shrinking.
- What is the cost of high leverage? With access to unlimited leverage, hedge funds can always find money to participate in hot momentum stocks and sectors; e.g., Biotech and Internet recently. Chasing momentum stocks increases portfolio volatility and leaves high-leverage funds vulnerable to momentum unwinds. While it’s clear that hedge funds are more leveraged, on average, than comparable mutual funds, there is little analysis on whether leverage adds or subtracts from risk-adjusted performance over full market cycles, including corrections.
- Does the liquidity discount (premium) change during times of market stress? An insightful research study on Hedge Fund Liquidity and Performance Evidence from the Financial Crisis was published in 2011 by German academic researchers Tobias Maier, Nic Schaub and Markus Schmid.http://efmaefm.org/0EFMSYMPOSIUM/Germany2012/papers/030.pdf
They found that when hedge funds are compared with each other, there is a modest liquidity premium that increases with a fund’s redemption restrictions. The harder it is for investors to redeem, the better the fund has performed, all else being equal. This is intuitive, because managers of the most illiquid funds have a larger opportunity set, including some investments that sell at a discount because of limited liquidity. However, these researchers also found: “In a crisis period, this share illiquidity premium turns into an illiquidation discount. Hence, greater managerial discretion seems to be harmful and share restrictions do not seem to be sufficient to manage illiquid assets effectively in a severe financial market crisis.” They cited as an extreme example Long Term Capital Management (LTCM), the huge (and very illiquid) hedge fund that nearly brought down the global economy in 1998, during a period of financial stress. Because LTCM managers believed they were protected from large-scale redemptions, they invested more aggressively and with far more leverage than was prudent. The illiquid assets then became nearly impossible to unload after word spread of the fund’s troubles.
- What is a liquidity option worth? During the financial crisis of 2008, a number of hedge funds imposed “gates” that thwarted investors’ ability to move money into cash and avoid losses. Alternative mutual funds contain the equivalent of an embedded liquidity option – the right to liquidate without question or delay during a crisis. Interestingly, none of the liquidity-discount analyses cited in this article assign any value to this option.
Today’s hedge fund industry is still running on the great reputation it earned more than 20 years ago, when it was far smaller. According to Pathlight Investors, the hedge fund industry grew from just under 2,000 funds (including fund-of-funds) in 1994 to more than 10,000 in 2007. Pathlight wrote: “The successful pioneers are usually the smartest and most capable, but as an industry grows and more people participate, the quality of the product diminishes as product differentiation becomes more difficult.” http://pathlightinvestors.com/hedge-funds-retail-investors-great-lie
In contrast, alternative mutual funds currently offer financial advisors a more select group of managers to evaluate, with far more transparency into their strategies and performance. Leading Long/Short Equity mutual fund managers have created a competitive track record that stands up well against comparable hedge funds. As alternative mutual funds grow larger and more cost-efficient, their performance advantages vs. similar hedge funds (net of fees) may become even more compelling.
The best test for evaluating hedge fund vs. alternative mutual fund performance may come with the next big stock market correction. Hedge funds may enter the downturn with far more exposure to thinly traded small-cap stocks in momentum-based sectors, which could increase pressure on prices. If long/short mutual funds weather the next market storm with more performance stability, perhaps the liquidity-discount argument can finally be laid to rest.
In summary, if you would like to introduce your clients to alternatives, there may no longer be compelling reasons to look back at the history of hedge funds. Instead, look forward and help them evaluate the best liquid alternatives. For more ideas, see: http://www.benefitspro.com/2014/04/25/5-ways-to-help-clients-navigate-liquid-alternative