By Aaron Filbeck, CFA, CAIA, CIPM – Associate Director, Content Development at CAIA Association
Whether it’s that some retail versions of alternative investments have not lived up to their private counterparts, or that retail investors may be last in the buffet line for private placements, there are several arguments against lowering the barriers to access alternative investments. The two arguments above are well noted, but I don’t know that they will stop the walls from coming down in the coming months and years. If increased access is a likely outcome, we should spend this precious time educating those who demand said access while advocating for thoughtful product execution from those who supply it.
We’ve already experienced the democratization of hedge funds for more than a decade. By gaining access to hedge fund-like strategies through liquid alternatives, retail investors have had an opportunity to incorporate alternative risk premia into their portfolios. However, as demand increased early, our industry started focusing on creating products and lost sight of the purpose behind them. As more products came to market, performance dispersion increased, funds were shuttered, and cynics began calling liquid alternatives a failure.
The failure of liquid alternatives wasn’t necessarily a result of the products themselves, rather it was the lack of thoughtfulness and investor education provided by our industry. Asset managers spent so much time trying to create silver bullets, they lost sight of the “why” behind them. As we venture towards democratizing private markets, we have a second chance to start with education, and finish with products. This time, let’s start with “why” and end with “what” and “how.”
The first question is critical: Why are you investing? What is this portfolio for? Having access to esoteric strategies might sound sexy, but does it fit with the overall objective you’re trying to achieve? If your client is a retiree and your objective is to collect a monthly cash flow distribution, I hate to tell you that investing a healthy portion of their portfolio in an aggressive tactical allocation fund or a Bitcoin trust might not be for you.
The second question scratches the surface of investment and operational due diligence: What kind of strategy is this? This is where I have wonderful memories of the liquid alternatives sales tactics: “this manager ran this exact same strategy in a hedge fund, but now they run it in a mutual fund” and/or “don’t worry, with this strategy, you can expect equity-like returns with bond-like risk.” There’s no such thing as a free lunch, and we should all be wary of geeks bearing gifts. Hearing these phrases should prompt further questioning and verification.
The third and final question is all about implementation: How might this fit this in my portfolio? Alternative investments have different risk and return drivers than traditional investments, and manager risk is highly prevalent as shown by performance dispersion. That merger arbitrage mutual fund might serve as a nice complement to your fixed income allocation, but that long/short deep value fund might not fit so cleanly into a style-box. Portfolio construction, position sizing, and risk management are just as important as the manager due diligence process.
Using the rollout of liquid alternatives as a case study, let’s learn from our mistakes as private markets are inevitably opened to more investors. Increased access and choice can be good for the end investor if done right, but we need to prioritize purpose over product. Creating demand for proper education, setting proper expectations, and acting in the best interest of the end investor are a good place to start.