What are liquid alternative funds?

Morgan Stanley Wealth Management


Summary: As investors explore ways to enhance returns and manage risk, liquid alternative funds have emerged as a potential choice. Learn what they are and what to consider before investing.

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Liquid alternatives or “liquid alts,” are mutual funds or exchange-traded funds (ETFs) that use non-traditional investment strategies in an effort to generate returns and provide diversification—sometimes regardless of broader market conditions.

Originally, access to these alternative-type strategies was only available through private investment vehicles such as hedge funds and reserved for qualified institutions and ultra-high-net-worth individuals. 

Today, the proliferation of liquid alts has made versions of these strategies available to a broader investor base. 

Not your typical fund

Liquid alternative funds employ various approaches that can include leverage, utilizing derivatives, and/or shorting stocks. Some follow “absolute return” or “market neutral” strategies that seek returns even when markets are down. Put simply, the goal of many liquid alternative strategies is to behave differently than the equity or bond market—or both—although no results are guaranteed.

At the same time, they are still regulated investment vehicles, meaning they are required to provide daily liquidity and pricing as well as regular reporting of their holdings. This also means that liquid alternative funds should not be confused with alternative investments such as hedge funds. Mutual funds and ETFs that seek alternative-like exposure are much more limited in the investments and strategies they are allowed to use.

As a result, returns and portfolio characteristics of liquid alts may be materially different from those of alternative investments, like hedge funds, that have similar investment objectives or follow a similar strategy. Ultimately, the returns of liquid alts will generally be more closely correlated with traditional market returns than alternative investments. 

Potential benefits

Still, when market watchers expect volatility on the horizon or a challenging environment with lower returns from traditional asset classes and investment strategies, some investors might explore liquid alts as part of a diversified asset allocation, seeking risk-adjusted returns with lower volatility.

Potential risks

As their name suggests, liquidity is a key characteristic of liquid alterative funds. However, some critics argue that their liquidity could be challenged during periods of market stress.

Also, the complexity of a fund’s strategy can make it difficult to understand its objectives and risks, and how it will perform in different market environments and over various periods of time. These strategies may expose the fund to increased volatility and unanticipated risks particularly when used in combinations or accompanied by the use of borrowing or “leverage”.

Know before getting started

Investors exploring these funds need to consider the firm, portfolio manager(s), strategy, and risks, which can be found in a fund’s prospectus. Another thing to keep in mind is that alternative-like funds are relatively new, so some funds only have a limited track record—making fundamental research more challenging.

Liquid alternative funds typically employ active strategies which can result in a higher portfolio turnover than traditional mutual fund and ETFs, potentially resulting in the generation of more reportable capital gains for taxable accounts.

Also, liquid alternative  funds typically have higher expenses than their traditional counterparts. For example, the average expense ratio of liquid alternative mutual funds and ETFs is roughly 1.48%, compared to 1.05% and 0.84% for the average US equity and fixed income mutual fund and ETF,1 respectively, not including any applicable brokerage or advisory fees.

Bottom line: While liquid alternative funds may be an option to further diversify portfolios and potentially enhance returns, they are not traditional in nature and investors should consider whether these strategies align with their individual investment objectives, risk tolerance, and time horizon.

  1. Source: Morningstar, 2021 U.S. Fund Fee Study, Equal-weighted average expense ratio of all active U.S. open-end mutual funds and exchange-traded funds, data as of 12/31/2021.

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