Five things you need to know before investing in liquid alternatives

1. The strategies most (and least) conducive to the liquid alternative structure. This is largely a function of the strategy's liquidity and leverage profile. Although in some instances, regulatory factors such as investment concentration can also come into play. Of the 24 distinct alternative investment classes, 10 fall outside regulatory requirements based solely on historical leverage and liquidity. This still leaves 14, or roughly 60%, of the total universe. From this group, our research ranks long/short equity, event driven and global macro as the three strategies that function best within a liquid fund structure. The three strategies presenting the biggest challenge — distressed assets, private equity and fixed income arbitrage — should be ruled out entirely in our opinion. 2. The expected value proposition of multi-alternative funds has not materialized. We continue to find advisers drawn to the multi-alternative fund structure's perceived benefits. On the face of it, the appeal seems logical — when advantages such as strategy diversification, expert manager selection and increased risk management are first presented. Unfortunately, in practice, the outcome has been highly disappointing for investors in traditional alternatives and this poor performance has carried over to liquid alternatives. It appears the layers of cost and fees involved present too high of a hurdle. As Simon Lack reports in his 12-year study of the hedge fund market, multi-manager funds consumed 98% of the strategy's profits. That's not a typo — investors received 2% of the pie while “managers” made off with the rest. The multi-alternative sector makes up more than 40% of all liquid alternative assets while the strategy produces the same lackluster returns. Morningstar's one-, three- and 10-year historical returns for the multi-alternative category are 3.29%, 1.96% and 2.35%, respectively. In this case, past performance is very likely an indication of future returns. You would be doing yourself a favor by investing in strategies directly. 3. Traditional risk measures and portfolio analysis can produce misleading results. Most advisers are quick to spell out uncorrelated returns as the primary benefit of alternatives but few understand how to conduct comparative analysis. The tendency is to look at the funds' return and volatility; which starts one off on the wrong path. With alternatives, it's a two-part process in which the first is simply qualification and then the second is measuring the material benefit for your portfolio. The necessary condition is uncorrelated, or non-systemic, returns. Without this, the investor is better off simply selecting a traditional long-only fund with the highest risk-adjusted prospects. Once you have identified a group of uncorrelated funds, the second step involves the tradeoff between return and correlation. Most portfolio modeling software falls short here by failing to incorporate this factor or attempting to do so based on the specific fund's metrics. With 90% of liquid alternatives lacking a statistically significant track record, any analysis tied to the sector's performance will produce misleading results. For the vast majority of advisers, we've found a simple approach that manages to capture 60% of the predictive benefits. The shortcut involves calculating the correlation statistics using the iShares Healthcare ETF (IHF) as a substitute. This index has the highest historical correlation with traditional alternatives. As a result it can be used to trick almost all portfolio software programs into calculating the normally elusive correlation statistic. Armed with this figure, any alternative fund's contributory benefit can be determined by incorporating it with the portfolio and fund assumptions for expected return and volatility. Now if you understand the reasoning for this modification, our experience puts you in the 95th percentile of liquid alternative investing professionals. 4. A few approaches to separate alpha from beta There may be no more controversial issue in finance than the proper methodology for calculating alpha. With alternatives however, you're spared this intellectual melodrama as the more important calculus involves beta. So evaluating an alternative fund's alpha really boils down to ensuring it's not simply beta in disguise. If the fund has greater than 35% asset concentration in its top 10 holdings, a review of the past year's quarterly filings can shed light on what contributed most to returns. Excess returns from long-only strategies that have ratcheted up risk are the clear red flags. Lastly, on balance, the ability to achieve alpha decreases as the total number of fund positions increases. So bear in mind that funds with holdings in the 400 to 500 range are unlikely to deliver anything more than reversion to the mean. 5. Last but certainly not least, how fund expenses compare With the difference in expense ratios between active and passive traditional mutual funds compressing to as little as 50 basis points, the margin for alpha would seem attainable. Yet data demonstrates most managers still do not exceed their benchmark. If you believe fees play a role in this underperformance, as research indicates, then you'll want to take a close look at liquid alternatives' expense ratios. Based on data from the 269 actively managed liquid alternative funds that meet our baseline criteria, the average fund expense ratio is 1.91%. Potentially more telling is the dispersion, as the top quarter has a range of 2.25% to 5.13% with an average of 2.8%. To put this into perspective, hedge funds' much maligned “2 & 20” fee structure equated to a 2.7% investor all-in fee using HFR Research's broadest index over a the past 15 years. If we were to include just the front-end loads, the top quartile's average fund expenses paid increases to 3.28% (assuming a five-year average holding period). In order to equate this to the hedge fund return series discussed above, investors in these liquid alternative funds would need to provide an outsized manager payout of “2 & 37.” As this nascent sector evolves and transparency improves, investors will increasingly find opportunities to make use of its unique ability to improve portfolio risk-adjusted returns. Dan Thibeault is the chief investment officer of GL Capital Partners, which publishes the Annual Report on Liquid Alternative Investments. He may be reached at dan@glcp.com.