Navigating liquid alternative investment strategies

Liquid alternative funds, commonly called liquid alts, were designed to offer exposure to a version of hedge fund–style investment strategies in a more retail accessible, exchange-traded fund (ETF) or mutual fund format. These funds are regulated by the Investment Company Act of 1940 (’40 Act) and must adhere to certain liquidity requirements, meaning shares can be traded each day.

As a result, liquid alternatives should not be confused with alternative investments such as hedge funds. Mutual funds and ETFs are much more limited in the investments and strategies they are allowed to use, which means returns and portfolio characteristics of liquid alts may be materially different from those of alternative investments 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 will.

Still, liquid alts are different from traditional ETFs and mutual funds. Traditional ETFs and mutual funds typically use a “long-only” investment strategy, with the goal of matching or outperforming specific market benchmarks over time. Liquid alternative funds, on the other hand, employ a wide array of strategies intended to deliver returns or hedge risk regardless of broader market conditions, although no results are guaranteed. Additionally, some alternative funds track commodities such as metals, energy, or agricultural products, as well as digital assets.

Not all liquid alternatives work in the same way. Some use strategies that try to behave distinctly different from the markets. Others take on non-traditional risks to offer diversified sources of potential return. Still others attempt to benefit from rising and falling markets as opportunities arise. These strategies can be helpful during periods of heightened volatility and market downturns—although they come with unique risks to consider.

For investors interested in navigating the world of liquid alts, below we break down some common strategies, as defined by Morningstar.  Please review the “Risks to consider,” as many of these categories rely on complex financial instruments and/or investment techniques that can make it difficult to understand a fund’s risks, as well as expose the fund to increased volatility and unanticipated risks.

While these alternative-style strategies may help investors diversify sources of potential risk and return, it’s important to understand they may ultimately lag or underperform the broad market. In addition to those discussed above, key risks to consider include:

• Liquidity. Liquid alternative funds are required by law to provide daily liquidity. However, during periods of extreme market stress, there have been instances where investors were not able to immediately redeem their shares. Liquid alternative ETFs are also more likely to trade at discounts to net asset value (NAV) due to the increased volatility and illiquidity often associated with their underlying investments.
• Complexity. These strategies can be complex, tapping into the most complicated financial instruments. It’s not always clear how funds may perform in different market environments and over various periods of time.
• Leverage. Leverage—borrowing capital to increase the value of a fund’s underlying portfolio—is a common feature in liquid alternative investment strategies. Often, funds use leverage in an attempt to amplify returns, but it can also result in outsized losses.
• Fees. High fees diminish investors’ returns and help explain the disappointing performance of some strategies.

Take time to read a fund’s prospectus and make sure you understand its investment objectives. The prospectus also includes a fund’s detailed risk disclosures and describes its charges and fees.

Learning more about a specific liquid alternative fund will help you determine if it’s suited for your goals, risk tolerance, and investment timeline.