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Liquid Alternatives: No easy alternative?

11 April 2016
The plummeting equity markets seen at the start of 2016 are a timely reminder of the need for diversity in investment. In August 2015 data provider Morningstar observed that liquid alternative (liquid alt) funds, mutual funds that manage investments using alternative fund strategies, fared better during that month’s equity market sell-off than popular index-trackers. From ‘Bear Market’ liquid alt funds (which were up 14.52%) to Long-Short Equity liquid alt funds (which on average fell 4.79%), the category typically proved more resilient than the S&P 500, which had fallen 9.43%, or the MSCI World Index which fell 8.85%, over the same period.
For investors, getting access to these heterogeneous funds is becoming easier as competition between providers increases; -assets under management grew from less than US$150 billion in 2010 to over US$300 billion in 2014. According to Morningstar the liquid alts segment of the market recorded an asset increase from USD$27 billion in 2008 to USD$304 billion in 2014, with the number of funds increasing over the same period from 482 to 1,569. Research provider Cerulli Associates forecasts liquid alt funds will represent 14% of total industry assets by 2023.
Regulation has brought ‘alt’ investment strategies closer to the mainstream, bridging the gap in understanding between what is traditionally retail focused investment projects and those used by professionals and high net worth individuals. The 2010 Dodd-Frank Act required alternative investment managers with more than US$100 million in assets to register with the Securities and Exchange Commission (SEC). By the end of 2012, the number of hedge fund managers registered with the SEC had increased by 50%. This became the first step for many managers to operate in a more regulated environment. Secondly, the JOBS Act has helped, albeit to a lesser extent, by allowing hedge funds to advertise and brand their products. This becomes powerful to an alternative investment manager since it allows them to discuss their strategy with a wider audience.
Yet the provision of liquid alternatives is by no means simple. If a traditional asset manager wishes to offer new strategies, or an alternative investment manager wants to wrap their strategy works within a traditional fund structure, a series of decisions need to be made to ensure the new product can function effectively, and in a compliant manner, for the investor. 

Careful construction 
Liquid alts usually tap a broad array of market instruments in both long and short positions and make heavier use of derivatives than typical long-only portfolios. Compliance and reporting – alternative funds are regulated under the Investment Company Act of 1940 (40 Act) – is a challenge, amplified by the number of sub-advisors and prime brokers used by the fund. For instance, when considering leverage limits, should the fund comply at the sub-advisor level or at the total portfolio level? Similarly, should the 40 Act limit on illiquid assets apply at the fund level or to each sub-advisor?
Crossing the line between traditional and alternative investment funds creates new operational models; working with a custodian in addition to the prime broker is new to some alternative managers and this comes with its own set of challenges. The heavier use of derivatives by some strategies and the associated need to work with multiple counterparties and manage collateral efficiently also adds to the complexity. Alternative investment managers need to have cash available for redemptions, not a concern for hedge funds’ more typical quarterly or even annual redemption periods.
The decision to structure as open-ended or closed-ended is determined by the investor base targeted, distribution channels and liquidity of instruments that the funds will invest in.

An exchange of expertise
Most recent launches are a combination of hedge fund and traditional managers where the traditional manager is bringing the expertise of operating in a regulated environment and the hedge fund manager is bringing their expertise of alternative investments. Roughly two-thirds of fund launches today are structured as multi-manager funds where each individual hedge fund sub-advisor is operating a sleeve of the overall fund portfolio. Over time, as both sides gain more expertise and investors get more comfortable, we suspect that we’ll see this ratio move to more single manager fund launches.
The rise of liquid alternatives has made it critical for fund managers to demonstrate robust, credible, institutional standards of technology infrastructure and business processes. By achieving operational stability, integrity and transparency across the full investment lifecycle, and inspiring the confidence of regulators and investors, hedge funds can broaden their range of eligible investors, supporting profitability and ongoing growth. To bridge the gap in experience between traditional and alternative investment provision, FIS helps our clients by providing all the technology and knowledge required to support the full investment life cycle through front, middle- and back-office.

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