Liquid alternatives showing huge growth potential

Liquid alternative mutual funds will enjoy enormous capital raising opportunities from the retail and individual investor market, but have been warned there are a number of risks and challenges that they need to be aware of.

The market for liquid alternatives is potentially massive. A study by the prime brokerage arm of Barclays in 2014 estimated there was approximately $19 trillion in investable assets from defined contribution (DC) pension schemes, individual retirement accounts, annuity reserves, broker dealers and registered investment advisers (RIAs). Nonetheless, liquid alternatives remain a small component of the roughly $13 trillion controlled by the US mutual funds industry. Preqin estimates that alternative mutual funds run approximately $240 billion.

“Individual or retail investors are a core growth market for liquid alternatives. A number of baby boomers are nearing retirement age and they are looking for investments that can provide an income replacement or downside protection. This is a huge market,” said Henry Davis, president at Arden Asset Management, speaking at the Liquid Alternatives Strategies Global conference in London.

DC pension funds are also potential investors. “DC plans have traditionally invested in stocks, bonds and cash. Over time, I believe DC plans will want to have more diversification to other strategies, and this will be a major driver going forward,” commented Davis.

A study by SEI, the fund administrator, stated that out of the $5.1 trillion controlled by DC pension schemes, 60% was invested into mutual funds. Many DC pension schemes are inherently conservative and some are suspicious of alternatives. Nonetheless, the same SEI study said plan sponsors were becoming increasingly comfortable with slightly more esoteric asset classes such as real estate as they seek out greater yields.

A Deutsche Bank study in September 2014 found demand for liquid alternatives to be increasing among investors. Two thirds of allocators told Deutsche Bank that they intended to increase their exposure to liquid alternatives. Deutsche Bank found managers have taken note and alternative mutual funds grew by 38% since 2008, compared with 13% for hedge funds, and 9% for US mutual funds.

A more recent study in 2015 of hedge fund managers conducted by the Alternative Investment Management Association (AIMA), the Managed Funds Association (MFA) and KPMG found 15% of respondents were looking to develop at least one alternative mutual fund product.

However, Davis acknowledged managers must be cognisant of the risks, particularly from regulators. The Securities and Exchange Commission (SEC) has been scrutinizing liquid alternatives. In April 2014, the SEC said it would review operations at 25 liquid alternative managers. The SEC announced in September 2015 that it would introduce provisions restricting liquid alternative managers from holding more than 15% of their assets in illiquid instruments. This instruction came as the SEC expressed concerns that market volatility or a severe credit event could force liquid alternative managers to sell assets quickly to meet their redemption terms. The regulator argued any rapid fire sale of assets would hurt investors and potentially upset liquidity.

Furthermore, the SEC urged liquid alternative managers to implement liquidity risk management procedures whereby assets are divided into liquidity categories. The SEC also said it would allow alternative mutual funds to introduce swing pricing.

Liquid alternatives have fared well despite some initial doubts. There were concerns that investment and leverage restrictions would make running liquid alternative strategies too unwieldy for hedge fund managers. However, this does not appear to have materialised.