Fixed Income Strategies

Flow of funds into alternatives starts to dry up

Key Points
  • A six- to seven-year period of rapid growth in alternative investments began to stall in 2014.
  • Interest picked up marginally in 2017, with hedge funds taking in $9.8 billion in new assets and managing a record high of more than $3.2 trillion at the end of December.
  • If the bull markets in stocks and bonds are over, however, an allocation to alternative funds could soften the blow.

With volatility returning to the stock and bond markets and valuations of almost all financial assets very high, alternative investments and alternative investing strategies should be popular. They're not.

"There is not as much interest in the alternatives space as one might expect, given the volatility in markets," said Tayfun Icten, a senior analyst at research firm Morningstar covering alternative investing strategies. "We have not seen a healthy comeback in alternatives."

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The financial crisis, when virtually all financial assets except Treasury bonds fell dramatically, gave life to the so-called liquid alt funds industry. The funds invest in a wide variety of alternative assets and hedge fund-like strategies intended to not correlate with the returns on stocks and bonds.

With such investments formerly available only to institutions and high-net-worth individuals, retail investors flocked into the hundreds of funds that were launched since the crisis.

Total assets in the alt funds stood at $223 billion at the end of March, with inflows of $1.9 billion for the month after falling about half a billion in February. Last year the category took in $4.8 billion in new money and another $5 billion in January.

"There was rapid growth in the liquid alternatives fund space for six or seven years, but it has basically stalled since mid-2014," said Icten.

No doubt the strong stock and bond markets post-crisis have tempered enthusiasm for expensive funds that offer uncorrelated (and lower) returns than on traditional assets. But the slowdown in growth has also been a result of consolidation in the industry. Many of the investing strategies of alt funds — such as market neutral, and long/short equity and credit — can manage only certain amounts of assets before the strategy starts to deteriorate. Many of the biggest and most popular funds from companies such as AQR and Boston Partners have closed to new investment. Other funds that failed to attract enough assets simply closed down.

"We're seeing consolidation in the industry," said Ictel. "The funds are getting bigger, and the number of overall funds is still falling."

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The demand for alternatives in the form of hedge funds also has moderated in the past two years, though the interest picked up marginally last year. After seeing outflows of $112 billion in 2016, the hedge fund universe took in $9.8 billion in new assets last year and managed a record high of more than $3.2 trillion at the end of December, according to data from Hedge Fund Research.

While several large institutional investors — most notably, the California Public Employees' Retirement System — abandoned hedge fund investing programs in the last few years because they were too costly and complicated to manage, many large institutions remain committed to the asset class.

The industry also has had to improve its offering in terms of cost. The "Two And Twenty" compensation model for hedge funds (2 percent of assets and 20 percent of profits) has gone by the wayside for all but the best performers. Institutions and high-net-worth investors are much more apt to negotiate hard on fees for hedge funds now.

The interest is still there, however.

"We still see consistent growth across investor groups," said Matt Jiannino, head of Quantitative Equity Product Management at Vanguard. "Some are interested for diversification purposes, others for risk reduction or return enhancement."

Vanguard's Quantitative Equity Product Management group manages $38 billion across a number of funds predominantly running market neutral and long/short equity strategies. They are marketed to institutions and financial advisors and are intended to diversify the risks of holding bonds and cash. The funds are accessible to individual investors, with most having a minimum investment threshold of $3,000.

With interest rates rising and the stock market increasingly volatile, Jiannino sees the demand for alternative investing strategies picking up. "Equity and fixed-income return expectations are low, and people are looking for ways to diversify their returns," he said.

Cost remains an issue in the liquid alternative funds market. The average fee for 1,645 alternative funds tracked by Morningstar Direct was 1.58 percent at the end of last year. Those costs are trending down, however, as demand for the funds has dropped and lower cost ETFs (average expense ratio 0.87 percent) become more popular with investors.

"A lot of these products tend to be high cost, and how much you pay can be crucial to the investment outcome," said Jiannino. As with hedge funds, the onus is on investors to do their research on both the costs and the risks being run in alt funds.

The collapse and liquidation of the $1.6 billion exchange-traded note run by Credit Suisse in early February is a case in point. The vehicle made hay shorting futures on volatility (VIX contracts) last year but lost 90 percent of its value in the space of a few days when volatility spiked in February. The vehicle — since shut down — was intended for active traders.

Morningstar currently tracks eight separate categories for alternative funds. They range from long/short equity funds that buy some stocks and short others, to managed futures that typically follow trends in commodities and futures markets, to multialternative strategies that combine various investing strategies. None of the strategies have outperformed the stock market for any length of time since the financial crisis, and they won't going forward if the market finds its feet again.

If the bull markets in stocks and bonds are over, however, an allocation to alternative funds could soften the blow. Just make sure you know what you're getting into.

"Investors need to understand the leverage used in a fund and the discipline of its investing strategy," said Morningstar's Ictel. "Alternative funds are more complex, and they're not for people who don't like doing research."

— By Andrew Osterland, special to