Liquid Alternatives: Dispelling the Myths

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1 January 11, 2013 Topic Paper May 14, 2015 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 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 a recent paper True Diversifiers: The Case for Multi-Strategy, Multi-Manager Hedge Strategies, dated March 2015 we highlighted the potential diversification benefits of alternative mutual funds, also called liquid alternatives. In our view, these funds 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. 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 For the purpose of this paper, we begin by defining liquid alternatives as mutual funds registered under the US Investment Company Act of 1940 (also known as 40 Act funds ) that utilize multi-strategy, multi-manager hedge strategies. Exhibit 1: Rapid 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 40 Act mutual funds and ETFs, as defined by the Morningstar US Open-Ended Multi-Alternative Category. Not FDIC Insured May Lose Value No Bank Guarantee

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 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 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 recent 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 Long/short equity: 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. As the data illustrate, liquid alternatives actually outperformed traditional hedge funds over the historical one-, three- and fiveyear periods, by margins of 228, 172 and 192 basis points, respectively. 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 some small degree of evidence in the data sampled. In fact, we observed the opposite. 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 example in Exhibit 4 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. Exhibit 3: Comparing Historical Returns of Liquid Alternatives and Traditional Hedge Funds As of March 31, % 4.36% 3.37% 2.81% 1.12% 0.36% 1-Year Cumulative Return 3-Year Annualized Return 5-Year Annualized Return Sample A HFRX Global Hedge Fund Index Source: Morningstar. Sample A is composed of all 10 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. 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. 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 performance and is where the supposed illiquidity premium arises. Mutual funds are required to invest at least 85% of their portfolios 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 85 long/short equity funds that we monitor. As the following exhibit indicates, roughly 64% of the aggregate holdings in these funds could be fully liquidated within one to five days, with 74% able to be liquidated within 10 days, and 80% within 20 days. Exhibit 5: Most Holdings in Long/Short Strategies Are Liquid As of January 2015 Time % of Portfolio Liquidated Less than 1/2 Day 10% Between 1/2 1 Day 5% Between 1 5 Days 49% Between 5 10 Days 10% Between Days 6% Between 1 2 Months 7% Between 2 3 Months 3% Between 3 6 Months 1% Greater than 6 Months 1% N/A 8% 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. 4

5 Our analyses of other strategies generate similar results. For the 15 event-driven funds we monitor, roughly 58% of the portfolios holdings could be fully liquidated within one to five days, 62% within five to 10 days, and 67% within 20 days. For the 27 global macro funds we monitor, roughly 95% of the portfolios holdings could be fully liquidated within one to five days, 96% within five to 10 days, and 97% within 20 days (all as of January 2015). 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. 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. For Franklin K2 Alternative Strategies Fund, for example, the median assets under management (AUM) for subadvising managers is $6.3 billion as of December 31, 2014, with the majority representing well-established managers in the hedge fund space. 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 40 Act rules that provide essentially the same exposures using different means (futures, options) to achieve the same 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 exhibit illustrates that the largest firms, while making up a minority of the industry, make up an overwhelming share of AUM as of year-end Exhibit 6: Estimated Distribution of Industry Assets by Firm AUM Tier As of Q By Number of Firms By Firm AUM Size < $100 Million (52.27%) $100 $250 Million (14.53%) $250 $500 Million (8.48%) $500 Million $1 Billion (7.26%) $1 $5 Billion (11.75%) > $5 Billion (5.70%) < $100 Million (1.36%) $100 $250 Million (1.92%) $250 $500 Million (2.48%) $500 Million $1 Billion (4.26%) $1 $5 Billion (22.83%) > $5 Billion (67.16%) Source: HFR Industry Reports, HFR, Inc. 2015, 5

6 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 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 face significant expectations of best-in-class operational support from pensions, corporations, endowments and other major institutional-quality investors. Institutional investors have high expectations of hedge fund managers: The days of two analysts and a Bloomberg terminal have long since passed. The infrastructure needed to fulfill these operational expectations can present a challenge to smaller hedge funds. Being a subadvisor to a 40 Act 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. The 40 Act structure prohibits direct borrowing for investment purposes, but, to a limited extent, applicable rules allow liquid alternative funds to utilize instruments such as futures, written options and short sales. 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 85 long/short equity managers we looked at previously in our illiquidity discussion exhibit an aggregate leverage level of 1.6 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. 6

7 WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. The market values of securities owned by the fund will go up or down, sometimes rapidly or unpredictably. The fund s performance depends on the manager s skill in selecting, overseeing, and allocating fund assets. The fund is actively managed and could experience losses if the investment manager s and sub-advisors judgment about particular investments made for the fund s portfolio prove to be incorrect. Some sub-advisors may have little or no experience managing registered investment companies. Foreign investments are subject to greater investment risk such as political, economic, credit and information risks as well as risk of currency fluctuations. Investments in derivatives involve costs and create economic leverage, which may result in significant volatility and cause the fund to participate in losses that significantly exceed the fund s initial investment. Lower-rated or high-yield debt securities involve greater credit risk, including the possibility of default or bankruptcy. The fund may make short sales of securities, which involves the risk that losses may exceed the original amount invested. Merger arbitrage investments risk loss if a proposed reorganization in which the fund invests is renegotiated or terminated. Liquidity risk exists when securities have become more difficult to sell at the price they have been valued. The fund may invest in investment funds, which may be more costly than investing in the underlying securities directly. Please see the prospectus and summary prospectus for information on these as well as other risk considerations. IMPORTANT LEGAL INFORMATION This commentary reflects the analysis and opinions of the authors as of May 14, 2015, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided are valid only as of May 14, 2015, and may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, strategy, industry, asset class or security. An assessment of a particular country, market, security, investment, asset class or strategy may change without notice and is not intended as an investment recommendation nor does it constitute investment advice. Statements about holdings are subject to change. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Your clients should carefully consider a fund s investment goals, risks, charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, please call Franklin Templeton Sales and Marketing Services at (800) or visit franklintempleton.com. Your clients should carefully read the prospectus before they invest or send money. 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 is composed of 10 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, as of March Holden and Schrass. Defined Contribution Plan Participants Activities, Investment Company Institute, April K2 Advisors, Franklin Templeton Investments, as of March See for additional data provider information. Franklin Templeton Distributors, Inc. One Franklin Parkway San Mateo, CA (800) franklintempleton.com Copyright 2015 Franklin Templeton Investments. All rights reserved. 5/15