Published by Bob Elliott and Johann Colloredo-Mansfeld on July 31, 2023 6:08:27 PM
Liquid alternatives products can offer complimentary diversifying returns that could benefit most portfolios. Unfortunately once the managers take their cut most of these products go from making sense to being a bad deal.
But there are diamonds in the rough that can benefit investors’ portfolios. Unfortunately, seemingly “rational” indicators like higher AUM or “you get what you pay for” fees generally aren’t strong indicators of quality. Products that are compelling should deliver alpha while also sporting lower fees relative to alternate approaches to accessing that alpha.
Below we evaluated performance over the last 5 years across 100+ liquid alt ETFs and mutual funds to give some perspective on the sector’s managers. We’ve attempted to distill it down to a few rules of thumb to aid in manager selection and offer insights into identifying the combination of attributes that could add value for investor portfolios.
Let’s start with the fees, which as you might expect, are too damn high.1 The figure below shows the distribution of AUM by the all-in fees charged to small-scale investors (including a 3-year amortized load if applicable). Almost 50% of investor capital is invested in products with a 3% or higher annual fee.
Source: Morningstar.
With the burden of those fees, on average, the industry takes ~100% of the alpha generated. The figure below shows the distribution of AUM by gross alpha (before fees). While we’d expect that the majority of investors are with managers that generate some alpha relative to a 60/40 benchmark portfolio, the concentration around the 3% gross alpha depicted below seems closely aligned with the 3% fees depicted above.
Source: Morningstar, Yahoo Finance, and Unlimited Calculations. Past performance not indicative of future results.
While many managers have skill, the problem is that the return profile most achieve doesn’t adequately justify the fees they are charging. It’s hard to generate alpha without some volatility. But when we look at our universe of funds, the data show that investors are primarily concentrated in products with low volatility. The average volatility of liquid alt products is 10%, but drops to 8% when weighted by AUM, which is less than half the 18% annualized volatility of the S&P 500.
Source: Morningstar, Yahoo Finance, and Unlimited Calculations. Past performance not indicative of future results.
As a result, for more than half the AUM in the sector, the managers’ fees erode the majority of the gross alpha, or more. The figure below depicts that only 19% of AUM is invested in funds where investors keep more than 30% of gross alpha. Managers seem to benefit disproportionately, and investors seem to be getting the short end of the stick.
Source: Morningstar, Yahoo Finance, and Unlimited Calculations. Past performance not indicative of future results.
Even though the sector as a whole is a bad deal, there are some good managers out there that generate solid alpha. The trouble is that it is darn near impossible to find them. That’s because the most logical indicators are unrelated to realized outcomes for investors. For instance, there is no obvious relationship between performance and fees.
Source: Morningstar, Yahoo Finance, and Unlimited Calculations. Past performance not indicative of future results.
Additionally, it is difficult to identify good individual strategies. There seems to be no obvious relationship between AUM and net alpha at the fund level indicating the market hasn’t yet found a tractable approach for selecting managers that offer strong fee-adjusted performance.
Source: Morningstar, Yahoo Finance, and Unlimited Calculations.
What is an investor to do given this picture? Well part of the story is to look for those managers that generate high quality alpha and don’t charge high fees. In that search, here are a few manager selection criteria:
- Greater than 2.0% annualized net alpha.
- Greater than 50% investor share of returns
- Less than 2.0% overall fees
Of the universe of 100+ liquid alts funds examined, only 12 met this standard over the last 5 years. Ironically nearly all of those 12 have well below $1bln in AUM.
Source: Morningstar, Yahoo Finance, and Unlimited Calculations. Past performance not indicative of future results
Selecting good liquid alts managers is tough since many strategies are opaque and the traditional indicators of good performance have proven unreliable. By screening managers to find those that charge reasonable fees relative to the alpha they generate, advisors and investors can identify quality complements to their portfolios. The key is to find those things that are somewhat counterintuitive – cases where managers aren’t raking in high fees for their work. It’s worth reviewing whether the premium paid is harvesting a reasonable return, or whether looking elsewhere might be more reasonable.
1 Fees are too damn high is a play on the single issue Rent Is Too Damn High Party that was an amusing piece of New York City politics from 2005-2010.
For informational and educational purposes only and should not be construed as investment advice. The historical analysis discussed herein has been selected solely to provide information on the development of the research and investment process and style of Unlimited. The historical analysis should not be construed as an indicator of the future performance of any investment vehicle that Unlimited manages. No investment strategy or risk management technique can guarantee return or eliminate risk in any market environment. No Representation is being made that any investment will or is likely to achieve profits or losses similar to those shown herein.