Why Alternative Investments and Daily Liquidity Shouldn’t Mix

Daily liquidity in alternative investments is like keeping a gun in your home – it might provide the illusion of security but statistics show it’s more likely to cause you harm.

Liquid alternative investments, known as liquid alts, are essentially hedge fund strategies in ’40 Act mutual fund clothing, offering daily liquidity on products designed to function with quarterly or even annual lock-ups. Liquid alt funds have exploded in popularity since the financial crisis, now numbering almost 600 with assets exceeding $300 billion. However, the rise of liquid alts has coincided with their waning efficacy as they have on the whole failed to deliver on promises of performance. 

Although SkyBridge has seen demand for a liquid alt product, we do not believe launching one would be in the best interest of clients for the following reasons:

1)     Alternatives are not, and should not be masqueraded as, mainstream products. Alternative investment funds, which include strategies like long-short equity, event-driven, structured credit, and managed futures, should make up only a small portion (5-30%, depending on individual risk tolerance) of any portfolio. Alts exist to diversify risk and smooth out long-term portfolio volatility. Traditional asset classes like equities and bonds, which comprise the majority of a portfolio, offer requisite daily liquidity. If you are looking for universal daily liquidity, you should not be investing in alternatives. Hedge fund investments can also be highly complex, and many of the strategies are not well-suited or designed to be implemented with daily liquidity. Knee-jerk, short-term decisions may harm an investor’s own long-term returns as well as negatively impact the fund’s performance.

2)      Liquidity provisions are one of alternatives’ greatest inherent competitive advantages over traditional asset classes. Investors are their own worst enemy, often choosing to sell assets at exactly the wrong time. Liquidity provisions largely protect investors from themselves while preventing fund managers from having to prematurely sell assets to satisfy withdrawals. In fact, in 2012 Deutsche Bank found that half of the liquid alts it studied underperformed the funds they were supposed to mimic, with an average liquidity premium of around 1%. SEC regulations even allow liquid alt funds to hold up to 15% of a portfolio in illiquid assets, creating potentially dangerous liquidity mismatches. For example, a fund with control positions in specialized credit or M&A trades could find themselves in a position where redemptions are being sought when capital is tied up in illiquid assets.

3)      Liquid alts are peddled to investors with increasing regularity because they can be, not because they should be. Mainstream investors generally underperform benchmarks because they try to create long-term financial plans using a rear-view mirror. Investors scarred by the financial crisis have been pushed increasingly into higher-fee liquid alts with the promise that “when the next crisis hits, you’ll be able to get your cash back.” However, since the financial crisis a low interest rate, highly correlated environment has led to outperformance by passive indexing strategies. Still, investment managers are encountering high demand for the illusory benefit of daily liquidity in sexy higher-fee alternatives.

4)      The preponderance of liquid alts creates systemic risks in financial markets. The reflation of assets by the Federal Reserve and increasing use of words like bubble and crash in the financial media has created a jittery investing public. At the same time, investors now have greater allocations to daily liquidity instruments. The combination of fear and false liquidity could exacerbate inevitable volatility when the Fed starts raising interest rates. Also, regulation like Dodd-Frank has decreased the likelihood of bank runs, but raised the possibility of runs on liquid instruments.

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Not all liquid alts are inherently bad, but right now the trade-offs between performance AND liquidity are too great. If managed correctly on their own, alternative investments and daily liquidity serve important functions in a portfolio, but combining them renders investors likely to shoot themselves in the foot.

Anthony Scaramucci is founder and co-managing partner of global investment firm SkyBridge Capital and host of the television program “Wall Street Week”