Liquid Alternatives: Dispelling the Myths

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1 January 11, 2013 Topic Paper 3 April 2017 PERSPECTIVE FROM K2 ADVISORS KEY POINTS The requirement to invest at least 85% in liquid assets does not appear to have a negative impact on historical performance relative to less liquid traditional hedge funds; in fact, historical data generally suggest the opposite. Industry dynamics provide incentive for quality hedge fund managers to subadvise liquid alternative mutual funds, giving investors a breadth of access to a universe of alternative strategies. Liquid alternative funds can utilize limited leverage through a variety of means to enhance return potential, and the perception that traditional hedge funds are heavily leveraged is not actually supported by the facts. In our view, alternative mutual funds, also called liquid alternatives, offer a compelling historical risk/return profile with the potential to help reduce anxiety-inducing volatility and to provide a return stream that exhibits low correlations to traditional asset classes. Such characteristics may be useful adjuncts to a typical stock and bond portfolio. The availability of liquid alternative vehicles has expanded rapidly over the past decade. Exhibit 1: Growth of Liquid Alternative Funds (US Mutual Funds and Exchange-Traded Funds) Billions $400 $350 $300 $250 $200 $150 $100 $50 $ Source: Morningstar. Historical assets held in publicly offered US alternative mutual funds and ETFs, as defined by the Morningstar US Open-Ended Multi-Alternative Category. However, this rapid growth has resulted in increased attention and scrutiny of this class of investment vehicle. Some market analysts have cited concerns over liquid alternatives, suggesting their structure may result in compromised return potential, lower manager quality and limitations on trading strategies. We believe these criticisms may in some cases be overstated, and in this paper we will discuss and address them. However, we will begin by clearly defining what we mean when we use the term liquid alternatives. A Multi-Strategy, Multi-Manager Structure As defined for the purpose of this paper, a multi-strategy, multimanager liquid alternative portfolio consists of several distinct hedging strategies (the multi-strategy component) that are managed on a day-to-day basis by outside hedge fund managers (the multi-manager component). Each of these third-party managers specializes in one or more specific hedging strategies. In this way, investors are offered access to institutional-quality hedge fund investment expertise with the benefits of daily liquidity provided by the mutual fund structure. We feel this strict definition is important, as we often see in trade journals and media outlets the term liquid alternatives used more broadly, perhaps incorporating global allocation funds, long-only strategies focused on real estate investment trusts (REITs) and/or commodities. While these and other strategies can be considered to be alternative, as they are alternative asset types, they are not alternative strategies, and as such are not included in our discussion of liquid alternatives. These other strategies do not

2 Exhibit 2: A Multi-Strategy, Multi-Manager Liquid Alternative Fund Structure Investor Investor Investor Investor Investor Investor Investor Investor Daily NAV Manager Has Full Transparency Consistent Fund Pricing Liquid Alternative Fund Event Driven Global Macro Relative Value Event Driven Global Macro Relative Value Subadvised Hedge Strategies Relative Value employ trading strategies that one would find at a traditional private hedge fund, which utilize a variety of asset classes, trading techniques such as shorting, and leverage to seek to achieve enhanced risk/return profiles. Our definition of liquid alternatives also focuses on those mutual funds managed by investment professionals with experience in real hedge fund trading, rather than products that simply utilize hedging or similar strategies. Vehicles managed by investment professionals without real hedge fund experience may not offer the same compelling risk/return profile. A study in the Journal of Financial and Quantitative Analysis supported this notion, suggesting that hedged mutual funds managed by managers with previous hedge fund investing experience outperformed those managed by professionals without a similar pedigree. 1 HEDGE STRATEGIES COMMONLY USED Event Driven: Based on corporate events such as mergers, reorganizations and management changes Global Macro: Focused on macroeconomic-driven opportunities across numerous markets and asset classes : Seeks to buy attractive companies and short sell weak companies to generate returns while helping to reduce unintended risks Relative Value: Looks for perceived pricing inefficiencies between markets or companies, or within the capital structure of a specific company 2

3 Criticisms of Liquid Alternatives: The Illiquidity Premium Liquid alternative mutual funds can deliver many benefits. Among them, as the name of the investment vehicle suggests, is daily liquidity, which traditional hedge funds do not offer. However, this benefit has sometimes generated criticism as well, such as the suggestion that the daily NAV structure may compromise return potential. This concept is often called the illiquidity premium, which refers to the perceived advantage that a traditional, less liquid hedge fund has in its ability to lock up capital for longer, and consequently invest in longer-duration assets that may have an enhanced return profile. However, our empirical examination of the actual performance and composition of liquid alternative funds and their traditional hedge fund counterparts illustrates the illiquidity premium may be overstated, and in fact very little is lost in terms of investment performance on the part of liquid alternatives. In the following chart, we compare various historical performance metrics of liquid alternatives to those of traditional hedge funds. Liquid alternatives are represented by a sample peer group of multi-strategy, multi-manager liquid alternative mutual funds that fall under the definition we discussed previously. 2 Traditional hedge funds are represented by the HFRX Global Hedge Fund Index. The HFRX index was chosen as a performance benchmark for current strategies because of what we view as its representation of investable vehicles, more stringent screening criteria and low level of reporting biases. Exhibit 3: Comparing Historical Returns of Liquid Alternatives and Traditional Hedge Funds As at 31 December % 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% 1.60% 2.50% 0.45% 2.92% 1.64% -1.0% -0.60% One-Year Cumulative Three-Year Annualized Five-Year Annualized Return Return Return Sample A HFRX Global Hedge Fund Index Source: Morningstar. Sample A comprises all 18 mutual funds within the Morningstar US Open-Ended Multi-Alternative Category that meet this paper s definition of multi-strategy, multi-manager liquid alternative mutual funds, based on their prospectus disclosure. The data is shown net of fees. Class A shares were used as the primary class. For funds not offering Class A shares, Class I shares were used. No fee adjustments were applied to Class I shares. For illustrative purposes only. As the data illustrate, liquid alternatives actually outperformed traditional hedge funds over the historical three- and five-year periods. It is important to note that the sample size in the previous analysis is small and the time period somewhat limited. Over longer horizons, we may expect results to vary, with quite a bit of return dispersion between the proxies included in the sample. Nonetheless, if there were a consistent drag on the performance of liquid alternatives associated with any sort of illiquidity premium, we would have expected to see a greater degree of evidence in the data sampled. Liquid alternative, multi-strategy, multi-manager funds may exhibit even more attractive characteristics when we include fees in our analysis. Accessing alternative strategies through a traditional fund-of-hedge-funds structure often results in higher fees than a liquid alternatives mutual fund, and the resulting fee-and-expense drag can have a pronounced effect on returns over time. The following example illustrates hypothetically the cost benefit of a given liquid alternatives mutual fund compared to a similar strategy accessed through a traditional fund-of-hedge funds. This assumes an annualized gross return of 10%, which in our experience is reasonable based on historical data for similar investment products. Examining this dynamic further, let us assume that the traditional fund-of-hedge fund maintains a 20% allocation to illiquid holdings not available to the liquid alternatives fund. If the impact of fees results in a 258-basis point difference in net return, as indicated in Exhibit 4, then the illiquid holdings would need to earn an additional 26.10% in incremental performance for the traditional fund-of-hedge fund to overcome the structural cost advantage of liquid alternatives. How Illiquid Are Traditional Hedge Funds Really? This discussion also raises the question of the extent to which traditional hedge fund models actually utilize their ability to invest in illiquid holdings, a capacity which underlies the theoretical advantage of the illiquidity premium. Through our analysis, while some strategies by their nature may lend themselves toward less liquid holdings than others distressed debt for example the majority of hedge fund managers that we review trade in highly liquid securities most of the time. This analysis suggests that the illiquidity premium may be limited in practice, due to the investment practices of traditional hedge funds that we observe. The perception of traditional hedge funds being illiquid likely stems from the legal terms they function under, which require in most cases a one-month to three-month notice period prior to redemptions. This represents illiquidity at a structural level, but not at a holdings level, which we believe has a more direct impact on 3

4 Exhibit 4: The Cost Advantage of Liquid Alternative Funds Has a Positive Impact on Overall Returns The Multi-Strategy, Multi-Manager Liquid Alternative Mutual Fund Has Less Fee-and-Expense Drag Than Many Traditional Funds-of-Hedge Funds Fees and Multi-Strategy, Multi-Manager Fees and Traditional Fund of Hedge Funds Expenses Return Liquid Alternative Mutual Fund Expenses Return Gross Annual Return 10.00% Gross Annual Return 10.00% Typical Hedge Fund Management Fee (2%) 2.00% 8.00% Typical Hedge Fund Performance Fee (20%) 1.60% 6.40% Typical Fund-of-Hedge-Funds Fee 1.00% 5.40% Management Fees 4.60% Management Fees 2.05% 7.95% Other Expenses 0.50% Other Expenses 0.47% 7.48% Total Expenses 5.10% Total Expenses 2.52% Net Annual Return 4.90% Net Annual Return 7.48% Cost Advantage: 2.58% Source: K2 analysis of RiskMetrics data. The hypothetical return comparison is based on 10% annual gross return. Traditional fund of hedge funds fees shown are represented by industry averages defined by the CAIA Association. Multi-strategy, multi-manager liquid alternative mutual fund fees are represented by the average fees derived from the sample peer group mutual fund prospectuses and do not include any applicable sales charges. For illustrative purposes only. Fees paid by investors in hedge funds vary significantly and, while 2% management fees and 20% performance fees have historically been considered typical for the industry, certain investors may pay lower fees. Performance fees for hedge funds may also be subject to a rate of return hurdle, which would have the effect of reducing the performance fees paid by investors at any assumed gross return. Investors in multi-strategy, multi-manager liquid alternative funds may invest in different share classes which may pay different fee and expenses than those shown above. In addition, investors may also be subject to an initial sales charge. Investors should consult the prospectus for a given multi-manager liquid alternative fund for more information about all of the fees and expenses paid by such fund. performance and is where the supposed illiquidity premium arises. US mutual funds are required to invest at least 85% of their net assets in liquid assets, but our analysis of traditional hedge funds that we follow indicates that very few of them are significantly different, with very few regularly allocating more than 15% of their portfolios to illiquid holdings for a long period, greater than three months. Again, some traditional hedge strategies by nature may lend themselves toward less liquid holdings, but in general our analysis indicates that a given traditional hedge fund strategy may not have the supposedly advantageous exposure to illiquid holdings that many critics assume. Going deeper into our analysis, in the following table, we look at the 74 long/short equity funds that we monitor. As the following exhibit indicates, roughly 73% of the aggregate holdings in these funds could be fully liquidated within one to five days, with 85% able to be liquidated within 10 days, and 92% within 20 days. Our analyses of other strategies generate similar results. For the 15 event-driven funds we monitor, roughly 88% of the portfolios holdings could be fully liquidated within one to five days, 94% within five to 10 days, and 98% within 20 days. For the 27 global macro funds we monitor, roughly 99% of the portfolios holdings could be fully liquidated within one to five days (all as at November 2016). Exhibit 5: Most Holdings in Long/Short Strategies Are Liquid As at November 2016 Liquidity Bucket Weight Less than 1/2 Day 0.00% 1/2 1 Day 0.00% 1 5 Days 72.87% 5 10 Days 12.56% Days 6.82% 1 2 Months 4.29% 2 3 Months 0.82% 3 6 Months 0.90% Greater than 6 Months 0.61% N/A 1.13% Total 100% Source: K2 analysis of RiskMetrics data. Illiquidity is defined as anything taking more than seven days to liquidate. Liquidity is defined as anything taking fewer than seven days to liquidate. As previously mentioned, some trading strategies are less liquid by nature, such as certain specialist credit funds, but in general our analysis suggests these represent the minority. As such the supposed advantage of illiquidity may in practice be very limited. 4

5 Criticisms of Liquid Alternatives: Manager Quality Skeptics often question the pedigree of the managers that agree to act as subadvisors for liquid alternative mutual funds, suggesting managers have no real incentive to do so if they are successful in the private space. We believe this is inaccurate. Information from Morningstar Inc. supports this assessment, showing that such established hedge funds as Wellington Management, AQR Capital Management, Coe Capital Management, Chilton Investment Company, Loomis Sayles, Jennison Associates, Chatham Asset Management, Graham Capital Management and York Registered Holdings all participate in liquid alternative fund structures. 3 Subadvising managers may be attracted to liquid alternative mutual funds because of a desire to diversify their investor base and to obtain a stream of inflows from the retail market. Furthermore, the breadth of hedge fund managers subadvising liquid alternative funds is well positioned for growth. In our experience, the majority of hedge fund managers have only recently started to realize that they have the potential to construct portfolios under public fund rules that provide essentially similar exposures using different means (futures, options) to achieve the economic leverage of their private vehicles. That is to say they can be managed in substantially the same manner as their existing products. The general understanding of the rules surrounding liquid alternative mutual funds by both the public and the hedge fund industry is constantly evolving, and those managers that have recognized the benefit of these structures have embraced their utility. Another issue impacting the breadth of available subadvising managers is the recent growth dynamics in the hedge fund industry as a whole. Investment assets in the sector tend to favor the largest brand-name hedge fund managers. The following Institutional investors have high expectations of hedge fund managers: The days of two analysts and a Bloomberg terminal have long since passed. exhibit illustrates that the largest firms, while making up a minority of the industry, make up an overwhelming share of AUM as at year-end Liquid alternative funds may prove attractive to hedge fund managers with less than $1 billion in AUM, particularly those with less than $500 million, because they offer access to so-called sticky assets that come with the subadvisory relationship. This effect gives liquid alternative funds a rich and diverse array of underlying managers from which to build their portfolios. One related area of growing interest to many liquid alternative fund managers is the defined contribution pension sector. Alternative strategies are currently finding their way into some target-date funds and other model portfolio structures within this large and lucrative market, though alternatives largely have not been adopted as standalone options. It is important to note that according to a 2013 study, only 10.7% of defined contribution participants changed the allocation of their account balances in that year. 4 This percentage represents a fairly stable (or sticky) pool of assets and a very attractive market for hedge fund managers both large and small, giving smaller parties further incentive to access the market through liquid alternatives. Another emerging issue impacting smaller managers is infrastructure. Hedge funds launching today are expected to provide best-in-class operational support from the pensions, corporations, endowments and other major institutional-quality investors they seek. Exhibit 6: Estimated Distribution of Industry Assets by Firm AUM Tier As at Q By Number of Firms By Firm AUM Size < $100 Million (49.37%) $100 $250 Million (14.86%) $250 $500 Million (9.33%) $500 Million $1 Billion (7.04%) $1 $5 Billion (13.19%) > $5 Billion (6.20%) < $100 Million (1.16%) $100 $250 Million (1.78%) $250 $500 Million (2.47%) $500 Million $1 Billion (3.65%) $1 $5 Billion (21.81%) > $5 Billion (69.13%) Source: HFR Industry Reports, HFR, Inc. 2017, 5

6 The infrastructure needed to fulfill these operational expectations can present a challenge to smaller hedge funds. Being a subadvisor to a public liquid alternative mutual fund provides another way for such a hedge fund manager to raise assets. Through this relationship, the operational, regulatory and other support tasks are typically fulfilled by the liquid alternative fund firm, and the hedge fund manager can focus on its core function portfolio management. Again, this approach provides significant benefit and incentive for quality managers to act as subadvisors in the liquid alternative fund sector. Criticisms of Liquid Alternatives: Limitations on Trading Strategies Another common perception of liquid alternative funds is that their trading strategies are restricted relative to those of private hedge funds. Again, we feel this criticism is overstated and is often based on false assumptions. Much of this criticism is rooted in the belief that liquid alternatives are not allowed to use leverage, a supposed limitation that means a liquid alternative fund s performance potential does not measure up to that of a private hedge fund. However, we believe this interpretation is not accurate: Liquid alternative funds can use limited leverage through various vehicles. Through these various forms of economic leverage, liquid alternative funds can and do employ similar trading strategies with similar outcomes as traditional hedge funds. Furthermore, this criticism over leverage is predicated on the notion that private hedge funds are aggressive users of leverage, but our analysis suggests this is not the case. The perception of heavy use of leverage may stem from the legacy left by the Long- Term Capital Management failure of However, our analysis indicates low average levels of leverage for example, the 74 long/short equity managers we looked at previously in our illiquidity discussion exhibit an aggregate leverage level of 1.9 times their capital base. 5 Yet averages can be deceiving, as some arbitrage strategies employ higher leverage, while others can have less than 100% of the capital invested. Conclusion Liquid alternative mutual funds have grown in popularity, with their ability to provide exposure to hedge fund strategies and potential returns with low correlations to stocks and bonds, plus the added benefit of daily liquidity. Critics have charged that liquid alternative funds have weaker returns due to their inability to invest in illiquid holdings, may not provide exposure to quality hedge fund managers, and exhibit lower performance potential due to restrictions on leverage. Throughout this paper, we have examined each one of these concerns, and found them to be overstated or even untrue. In our opinion, liquid alternative mutual funds have the potential to provide significant value for investors, whether on their own or as part of a portfolio with traditional assets. There remain differences between liquid alternatives and traditional hedge fund strategies, and while it is important to continue to monitor and study these differences over time, it is equally important to distinguish fact from mere perception, and to not let common assumptions about liquid alternatives override their potential benefits. WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. The market values of securities will go up or down, sometimes rapidly or unpredictably. A subadvised portfolio s performance depends on the manager s skill in selecting, overseeing, and allocating assets. Actively managed portfolios could experience losses if the investment manager s and sub-advisors judgment about particular investments made for the portfolio prove to be incorrect. Some sub-advisors may have little or no experience managing registered investment companies. Investments in derivatives involve costs and create economic leverage, which may result in significant volatility and cause a portfolio to participate in losses that significantly exceed the initial investment. Liquidity risk exists when securities have become more difficult to sell at the price they have been valued. A portfolio investing in other investment funds may be more costly than investing in the underlying securities directly. IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments ( FTI ) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user. 6

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This is not an offer to sell or a solicitation of an offer to purchase securities in any jurisdiction where it would be illegal to do so. 1. Agarwal, V., Boyson, N.M. and Naik, N.Y. Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds. Journal of Financial and Quantitative Analysis. Vol. 44, No.2 (2009), pp The sample comprises 18 mutual funds selected from the Morningstar US Open-Ended Multi-Alternative Category that meet this paper s definition of multi-strategy, multi-manager liquid alternative mutual funds, based on their prospectus disclosure. All mutual funds within the Morningstar Multi-Alternative Category that meet this definition are included. 3. Morningstar Inc., as at December Holden and Schrass. Defined Contribution Plan Participants Activities, Investment Company Institute, April K2 Advisors, Franklin Templeton Investments, as at March Important data provider notices and terms available at Please visit to be directed to your local Franklin Templeton website. Copyright 2017 Franklin Templeton Investments. All rights reserved. 4/17