Warren Buffett once said, "Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."
Calpers must've been feeling a little wet when
it announced a complete divestment of its $4 billion in hedge funds. Last fiscal year, the nation's largest pension fund paid $135 million in fees for a 7.1% return. During that same time period, the S&P returned around 20%. That's one heck of a leak.
Numbers like this may be shocking, but they aren't new. In fact, hedge funds have been underperforming the broader market since 2008, and they continue to do so.
By the end of August, the S&P was up around 10% for the year. Hedge funds, as represented by the Hedge Fund Research Index, returned a mere 4% during the same timeframe.
Poor returns like this, coupled with Calpers' influence in the pension fund space, mean that more institutional outflows are likely. With public and private pension funds making up approximately 40% of hedge fund assets, any imitation of Calpers' exit from the industry will have large ramifications. But it also raises a question: If an institution with the clout and resources of Calpers cannot justify hedge fund investing, where should advisers turn for alternative asset exposure?
The answer could possibly be liquid alternatives, the veritable offspring of traditional hedge funds. Now if you take issue with this admittedly counterintuitive positon, I'd ask you spare me a second to explain before taking your quarrel to the comment section below. If you remain unconvinced after, well then by all means, light me up.
(Related read: Liquid alts are a threat to hedge funds as we've known them)
In concept, most liquid alts are little more than hedge funds administered within a regulated marketplace. Combine this with the fact that the sector's performance has left much to be desired, and it's obvious why one could fail to see their white-knight potential. Our position does not rest on the funds' strategy or preliminary performance, however. It's our belief that liquid alts' regulatory overlay — deemed by most to be an overly restrictive handicap — provides a solution to the primary issues which Calpers identified as disadvantages for hedge funds.
(Also: 5 things you need to know before investing in liquid alts)
The first is risk and consistency. Without explicit restrictions on leverage and investment mandate, hedge funds often experience material shifts in fund leverage and style. In what turned out to be an ill-advised quest for superior alpha, LTCM, the famous hedge fund run by Nobel laureates, increased its leverage to more than 100:1. Liquid alt managers, on the other hand, face no such temptation. Regulations limit their leverage to 30%. Likewise, the structure of liquid alts precludes material style drift, the surreptitious changing of strategy in the pursuit of returns. By avoiding style drift and excess leverage, investors are presented with a lower risk profile as well as the ability to conduct proper portfolio risk management due to the stable fund parameters.
While the Investment Advisers Act of 1940 regulations do not stipulate a specific cap on liquid alts' fund fees, the limitations on carried interest has removed hedge funds' largest tool for extracting fees. While hedge funds commonly charge a 2% management fee and 20% of returns, liquid alts average an expense ratio of less than 1.8%.
In addition to lower costs, liquid alts offer greater flexibility. They're called liquid alts for a reason. While many hedge funds have lockup periods that can last years, liquid alts can be bought and sold on a daily basis. This means that individual investors can vote with their feet against underperformance — while investors in hedge funds are locked in. More sophisticated advisers can also leverage this liquidity to
better manage clients' alternative exposure with tactical overlays.
Pension funds and endowments are demanding better performance, lower fees and more consistency and transparency. These are the traits that liquid alternatives are well suited to provide. As with any market, it won't always be smooth sailing, but when the waves get choppy, at least you won't find yourself in a leaking ship.
Dan Thibeault is the chief investment officer of GL Capital Partners, which publishes the Annual Report on Liquid Alternative Investments. He can be reached at dan@glcp.com.
