Beachhead Capital Management has published a white paper on what it calls the “second generation of liquid alternatives.” To begin at the beginning, “liquid alternatives” are investment products, available to retail investors, for example through mutual funds or ETFs, which are designed to provide the diversification and absolute-return benefits typically associated with hedge fund strategies. Liquid alts offer these strategies far beyond the bounds of the limited class of qualified investors who can avail themselves directly of the hedge funds. The first generation came into existence in the wake of the global financial crisis. But growth in the field has slowed, the paper finds, as the promised diversification benefits – what one might fairly call the “hype,” – failed many of the investors naturally attracted to the idea. Also, the fees were too high for the market. The investors came to understand that they were paying sub-advisory fees and other expenses as well as the top-line fees. The paper from Beachhead maintains that Generation Two products will address these issues. One underlying institutional issue involves the mechanics of “filling a bucket.” If a cost-conscious investor has a fixed share of assets under allocation that it wishes to expose to the risks and returns of large-cap U.S. equities, it is said to have such a “bucket” to fill. Nothing is easier in that case: it can buy an ETF exposed to the S&P 500. Filling the Hedge Fund Bucket Now: suppose that it wants to fill up a hedge fund bucket. That’s tougher if it is an institution with pockets of only modest depth. A deep-pocketed institution can and will diversify across dozens of funds in order to try to get the diversification right, because as this white paper says “idiosyncratic manager risk is much, much higher” in hedge funds than in stocks or other traditional assets. But of course the whole idea of liquid alts has always been to introduce certain strategies to those whose pockets aren’t as deep as those of the usual qualified investors. This means introducing them to asset allocators who can’t offload idiosyncratic managerial risk so easily. A related but distinct problem for retail investors attracted to the liquid alts world: an investor can pick a fund in reliance on a star performer at the top or on the trading desk, and that star can go cold, or leave, so that investors experience the hangover rather than the party. In the words of Andrew Beer, managing partner at Beachhead, “Today, allocators understand that consistency and predictability over a market cycle are essential to reach long-term goals, and that low fees are the surest path to capital appreciation.” The next generation products, he added, “will focus on outcomes and be built for the needs of allocators.” Sometimes first generation liquid alts addressed its problems with multi-manager products intended to offer a “one stop solution.” These products were analogous to old-school funds of funds. But the multi-manager liquid alt mutual funds ran into two problems: poor net of fees performance and particularly high fees. Over the last five years, the white paper says, these sorts of funds have returned just 1.9% per annum. “In retrospect, sponsors underestimated the degree to which mutual fund constraints would hinder performance in many hedge fund strategies.” Replication Saves the Day The Generation Two solution is hedge fund replication. The idea is to identify the core market drivers of the performance of the hedge fund strategies at issue, and then replicate those drivers within the mutual fund constraints. Replication funds have been around for a decade, and although they have not remained constant since creation, they have created a (heartening) track record. Simple replication based products have “materially outperformed both the illiquid and liquid hedge fund indices with comparable standard deviation and lower drawdowns through the crisis.” Looking at equity, the white paper says that a simple five-fa ctor replication can reproduce the pre-fee returns of the HFRI Equity Hedge Index. Net of fees, this replication “would have outperformed by 60 bps per annum with a correlation of close to 90% -- exactly what a Generation Two product is supposed to achieve.” In short, the danger now is that the failure of Generation One will sour too many investors on the whole idea of liquid alts, and the promise of the space will go unrealized.
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