Predicting the Future of the Liquid Alt Industry

Nicholas Colas of Convergex had a piece out last week on the state of the liquid alt fund universe. For those that aren’t familiar with liquid alts, here’s a nice summary from Colas:

Liquid alternatives are the U.S. financial industry’s biggest disruptive innovation since ETFs: they’ve grown sevenfold over the past decade to +$340 billion. Goldman Sachs projects that liquid alts will accumulate $2 trillion in AUM over the next 5-10 years, a threshold ETFs crossed just last month. Even with explosive growth, a lack of understanding of the products and their proper roles in portfolios continues to cloud the asset class. So what are they exactly and what’s driving such huge demand? Liquid alts are hedge fund strategies in the form of Investment Company Act of 1940 wrappers (i.e. mutual funds or ETFs). Liquid alts democratize alternatives by providing retail investors with access to these advanced strategies that were previously reserved for high net worth individuals. The financial crisis helped spur demand for liquid alts as investors sought new forms of diversification.

Goldman Sachs believes this will be a $2 trillion business in assets under management within 5-10 years. I wouldn’t be surprised if they’re right. But how do we get from here to there? What follows is my theory on how the liquid alt fund growth will occur.

Professional investors and pundits have been predicting much lower returns for both stocks and bonds for a number of years now. They’ve been wrong, but eventually it will happen. There will either  be a bear market or a string of poor annual returns in each of these two main asset classes. This is how risk assets work.

When this happens — from a recession, a bear market or a rise in interest rates — and we go through a volatile period in the markets, there will be liquid alt funds that protect investors from this volatility. Not all of them, but there will be a handful that show extraordinary performance in the face of losses elsewhere. There will be liquid alt funds that protect on the downside with very low levels of volatility, something most investors dream of.

What follows will be enormous inflows into these best performing funds, but only after the fact. It’s unfortunate that this is the case, but this is how mutual fund flows into hot products usually work. Investors are constantly fighting the last war with poorly timed purchases and sales.

Plenty of the current crop of funds will close when they don’t pan out. Many new funds will open. Most of them will be in the styles or strategies that work. Some of these will be legitimate and do what they say they’re going to do. Most won’t. This isn’t unique liquid alt funds. The mutual fund graveyard is full of funds in all asset classes that close or merge on a consistent basis.

Many investors are worried about U.S. stock and bond returns from these valuation and interest rate levels. Just don’t pretend these liquid alt funds are going to be your savior. Everyone says they want uncorrelated assets in their portfolio until they start performing differently in the wrong direction and underperform. Investors only want uncorrelated returns when they go in their favor. You have to set reasonable expectations and realize that diversification requires patience to work out over time. Nothing works in every single environment.

I’m skeptical that there are going to be $2 trillion worth of legitimate liquid alt funds that will work as they are marketed, but that’s to be expected. Not every investment product can live up to lofty expectations. If you really want the diversification benefits of liquid alt funds then do it before something happens, not after. Make it a core holding in your portfolio, not something you jump in and out of based on market moves. Otherwise you’ll always be investing in the rear-view mirror.

I could be wrong about this, but the history of the mutual fund industry tells me this is the path we’ll see.

Further Reading:
In Pursuit of Past Performance

Here’s what I’ve been reading this week:

  • What degree of forecasting is bad for your wealth? (Prag Cap)
  • The perils of trying to time the market (Brooklyn Investor)
  • What matters most in investing? (White Coat Investor)
  • Howard Marks on the benefits of reading broadly and being a generalist (ValueWalk)
  • Are commodities too bad to be true as an asset class? (Servo Wealth)
  • What do we know about investing but can’t prove with stats? (Michael Santoli)
  • “The effort you need to put into investing is front-loaded.” (Monevator)
  • Time is on your side in the stocks market, even for older investors (What Works on Wall Street)
  • It’s a sector-picker’s market (See It Market)
  • Two great podcasts on behavioral psychology: Morgan Housel & James Osborne (Bason) and Patrick O’Shaughnessy & Barry Ritholtz (Big Picture)
  • Tom Hanks on why he owes it all to community college (NY Times)
  • The secret to raising smart kids (Scientific American)

Subscribe to receive email updates and my monthly newsletter by clicking here.

Follow me on Twitter: @awealthofcs

This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

The Compound Media, Inc., an affiliate of Ritholtz Wealth Management, receives payment from various entities for advertisements in affiliated podcasts, blogs and emails. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. For additional advertisement disclaimers see here:

Please see disclosures here.

What's been said:

Discussions found on the web
  1. Steve commented on Jan 17

    You didn’t tell us what liquid alts are, except that they are hedge funds. That’s it? What do they look like, how do they work, and so on?

    • Ben commented on Jan 19

      Liquid alts are simply alternative investments that are available as mutual funds or ETFs. They could be long/short funds, market neutral, commodities, options strategies, merger arbitrage, leveraged funds, etc. It’s very difficult to describe the entire fund universe because there are many different strategies. In general, these funds look to offer diversification and correlation benefits outside of the stock and bond markets. Most of the time there is a premium fee paid for this. The jury is still out.

  2. Money Maven commented on Jan 18

    You also forgot to mention Convergex just launched one of these funds. Maybe that clouds their view a little?

    • Ben commented on Jan 19

      Fair point, but they did use data from a Goldman Sachs report when describing the market for these funds. And if they are in the fund universe they have a front row seat to describe how it all works (even if that view could be tainted by the fact they have a fund).