Wolf in Sheep

False Diversification: Liquid Alts

Wolf in Sheep

After two severe markets corrections in the same decade -- 2002's tech wreck and 2008's credit crisis -- a wave of mutual funds touted as 'liquid alternatives' has flooded U.S. investors.

The underlying driver of such a proliferation is a push to find new ways to cushion against market stress by expanding on an old theme: portfolio diversification.

Nobel Laureate Harry Markowitz was one of the first academics to identify the benefits of adding additional assets to a portfolio. His work in understanding risk and how it applies to stock markets was seminal in the development of what became modern portfolio theory.

In theory, assets with different correlations but similar expected returns can reduce the overall volatility of a portfolio without sacrificing expected return. This principle is why Index Fund Advisors designs portfolios to provide clients with passive exposure to 45 different countries and more than 13,000 individual companies around the world.

Unfortunately, certain practitioners have been promoting a perverted view of Markowitz's original principle. This is largely being done by bundling into mutual funds a variety of investment strategies similar to those favored by hedge funds and other active managers. Combined with illiquid and often rather exotic asset classes, liquid alts aim to increase diversification, albeit at a higher cost to end-users.

Throughout recent post-recession periods, these strategies have increased dramatically. (See chart below.)

Number of Liquid Alternative Mutual funds in US

Based on data provided to us by Dimensional Fund Advisors, we can see how liquid alts have proliferated across domestic fund markets. It's probably important to note as well that hedge fund techniques are common components of such investment vehicles. These include strategies usually referred to as: long/short, market neutral, absolute return and managed futures. (See definitions for each at the end.)

While many are selling liquid alts as an asset class unto itself, the reality is that they are largely different active strategies that are being repackaged. As we would expect, recent past returns have proved very disappointing.

In a new research report aptly named "Alternative Reality," analysts at DFA crunch data comparing liquid alt mutual funds with at least $50 million in assets under management and a minimum of three years worth of return histories. (See chart below.)

Performance and Characteristic of Liquid Alternative funds

From June 2006 to December 2017, this group produced an annualized return of 0.83%.  In that same period, a proxy for relatively risk-free investing (one-month U.S. Treasury bills) came out ahead. To make matters worse, a typical investor had to pay 1.42% a year for such underperformance -- while taking on significantly higher levels of standard deviation, a measure of market risk.

But that's not all. In aggregate, these funds were severe laggards to the Russell 3000 Index, which provides broad long-only exposure to U.S. equities. Liquid alts also failed miserably in this 10-plus year stretch in keeping up with the Barclays U.S. Aggregate Bond Index, a widely diversified benchmark tracking investment-grade domestic fixed-income markets.

In reality, the evidence seems clear to us that this type of alternative investment is just a wolf in sheep's clothing. Liquid alts amount to little more than an expensive shell game to complicate and obscure one of the most straight-forward and dependable concepts of investing -- diversifying across a passively managed and globally allocated portfolio of publicly traded stocks and bonds.


Absolute Return: Funds that aim for positive return in all market conditions. The funds are not benchmarked against a traditional long-only market index but rather have the aim of outperforming a cash or risk-free benchmark.

Equity Market Neutral: Funds that employ portfolio strategies that generate consistent returns in both up and down markets by selecting positions with a total net market exposure of zero.

Long/Short Equity: Funds that employ portfolio strategies that combine long holdings of equities with short sales of equity, equity options, or equity index options. The fund may be either net long or net short depending on the portfolio manager's view of the market.

Managed Futures: Funds that invest primarily in a basket of futures contracts with the aim of reduced volatility and positive returns in any market environment. Investment strategies are based on proprietary trading strategies that include the ability to go long and/or short.

Category descriptions are based on Lipper Class Codes provided in the CRSP Survivorship bias-free Mutual Fund Database.