Opinion and Investing Column

Skarbeck: Lots of reasons to avoid 'liquid-alt' mutual funds

July 12, 2014

Ken SkarbeckInstitutions are not the only investors seduced by hedge funds. The hottest thing going with individual investors is mutual funds that mimic hedge fund strategies. Over the past year, $95 billion, or nearly $2 of every $3 invested into mutual funds, has flowed to “alternative” mutual funds, also called “liquid-alts.”

In a recent Wall Street Journal column, Jason Zweig noted, “Many banks and brokers are urging their salespeople to put 20% of their client assets into ‘liquid-alt’ funds.” The Securities and Exchange Commission has taken notice of this explosive growth and plans to review the marketing and investment strategies these funds employ.

The largest broker-sold liquid-alt fund is MainStay Marketfield, at $20 billion. It is a long/short fund, meaning the managers can both buy stocks they expect to rise in price, and sell short stocks they believe will decline in price. The fund tripled its assets in 2013 with inflows of $13 billion. Yet over the past five years, the fund has trailed the S&P 500 index.

In the first half of 2014, the Marketfield fund has lost 3.5 percent vs. a 7-percent gain by the S&P 500. Investors pay a “load,” or commission, as high as 5.5 percent to buy the fund’s shares, in addition to an annual expense fee of 2.93 percent.

One high-profile liquid-alt fund recently announced it is folding. The Natixis ASG Diversifying Strategies Fund was managed by Andrew Lo, an MIT finance professor who is renowned in the world of financial academia.

The fund’s objective was to seek “absolute return”—in other words, positive returns in up markets, with smaller declines in down markets. The fund used derivatives to replicate strategies that are employed by institutional hedge funds.

In 2010, Diversifying Strategies rose 8.5 percent versus 15 percent for the S&P 500 index with dividends. For some reason, investors poured into the fund, and assets reached $419 million by 2012. Yet the fund lost 2.7 percent in 2011, 7.7 percent in 2012, and another 8.1 percent in 2013.

The way alternative funds claim to work is, they do well when stocks do poorly—and vice versa. The big mistake is that alternative funds became popular after the financial crisis’s damage had been done. Thanks to Wall Street’s penchant for identifying what will sell, a slew of liquid-alt funds have formed in the past few years to capitalize on investors’ fear and mistrust of the stock market, similar to what drives institutions’ craving for their hedge fund brethren.

Proponents of liquid-alts and hedge funds say, wait until the next market decline and they will shine. Well, perhaps, but investors who prudently mind their portfolios and raise their cash position as stocks get pricier will do just fine and have dry powder to invest if stock valuations fall too far.

Considering that annual fees can run 3 percent or more, and investment performance for the vast majority of these funds has been subpar, if offered a liquid-alt mutual fund, our decision would be to pass.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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