When a ‘Liquid-Alt’ Fund Loses Steam

Jun 20, 2014

THE INTELLIGENT INVESTOR

When a ‘Liquid-Alt’ Fund Loses Steam

JASON ZWEIG

If you trade up for a “liquid-alternative” fund, make sure you understand you also are making a trade-off.

That is the lesson that emerges from the rise and fall of the Natixis ASKN.FR -1.19%G Diversifying Strategies Fund, a pioneering portfolio that has just been put out of its misery by its manager.

Liquid-alternative funds generally offer the prospect of doing well when U.S. stocks do poorly. That hope comes at a price, however: Such funds, which tend to charge high fees, typically do poorly when U.S. stocks do well. Investors who don’t understand this link will inevitably be sorry.

Many banks and brokerages are urging their salespeople to put 20% of their clients’ assets into “liquid-alt” funds. Over the 12 months ended May 31, such portfolios took in $98.8 billion of new money from investors, according to Lipper, the fund-research company. All stock and bond funds combined took in $147.5 billion over the same period, meaning that two out of every three dollars that came into mutual funds went into liquid alts.

One of the earliest of these funds was the Diversifying Strategies fund, run by AlphaSimplex Group, a money-management firm in Cambridge, Mass. The founder and chief investment strategist of AlphaSimplex is Andrew Lo, a finance professor at the Massachusetts Institute of Technology and director of the MIT Laboratory for Financial Engineering. If the phrase “He’s no dummy” didn’t exist, it would have been invented to describe Prof. Lo.

Launched in 2009, Diversifying Strategies set out to achieve “absolute return,” or positive performance in up markets and less-negative performance in down markets.

The fund used futures contracts and other so-called derivatives to mimic the return and risk of various hedge-fund strategies, including currency hedging, commodity trading and other techniques. These approaches historically have done well when stocks have done badly—and have generated returns that can help smooth out the bumpy ride of a stock-and-bond-centered portfolio.

In 2010, the fund’s first full year, U.S. stocks gained 15%. Diversifying Strategies was up 8.5%—but its returns were much less herky-jerky than those of the stock market. Investors piled in, and by January 2012 the fund’s assets peaked at $419 million.

But the tables already had turned. Around the world, central banks were driving interest rates down, wreaking havoc on the performance of “global macro” hedge funds—whose returns the Diversifying Strategies fund was partly designed to mimic. The fund lost 2.7% in 2011, 7.7% in 2012 and another 8.1% in 2013—even as U.S. stocks rose 2.1%, 16% and 32%, respectively. The fund also underperformed the Barclay Hedge Fund of Funds Index by 4.2 percentage points annually since its launch.

At last count, Diversifying Strategies’ assets had shriveled below $15 million. On June 13, the fund’s board of directors voted to close and liquidate it, giving the remaining investors their money back.

The decision, said Natixis in a statement, “was based on the fund’s small asset level relative to the cost of implementing these more sophisticated strategies.”

The fund’s siblings have done better. The Natixis ASG Global Alternatives Fund, for example, seeks to replicate the returns of a wider spectrum of hedge-fund techniques, such as convertible-bond trading and “event-driven” portfolios that attempt to cash in on mergers or other corporate changes.

Global Alternatives has $2.9 billion in assets, attempts to minimize short-term risk and has outperformed the Barclay fund of funds index by 3.5 points annually since its launch in September 2008—although it, too, has trailed the bullish stock market by a wide margin.

Diversifying Strategies’ results are “disappointing, certainly,” says Prof. Lo. “But the fund was designed to provide alternative sources of expected risk and return, and it did exactly that.” He adds: “This is what diversification is supposed to look like.”

Speaking of liquid-alternative approaches in general, Prof. Lo says, “When equities are doing well, you’re not going to like this strategy. When they’re doing poorly, you will.”

That might sound like a cop-out, but Prof. Lo is making a point every current or prospective investor in liquid-alt funds had better understand.

“There’s no doubt that everybody will look stupid when the S&P is up 30%,” he says. “That’s when it will be a challenge to remember why you bought in. That’s human nature. Only after the froth blows away and stocks go down will [investors] remember, ‘Oh, I needed to hedge.’”

If you want an investment that can do well when stocks and bonds do badly, a liquid-alt fund can do that for you. But you will have nobody but yourself to blame when stocks and bonds do well and you get annoyed at your alternative fund for underperforming. That is what it is supposed to do.

If you can’t accept that, maybe you should just keep some of your money in cash.