Access alternatives: platforms, not products
Investing in the alternative investment asset class has always been difficult. Over the years, various investment solutions have claimed to open access to strategies previously reserved for wealthier institutions and families. But more often than not, the solutions — whether hedge funds of funds, liquid alternative funds or interval funds — have been poor facsimiles of the real McCoy.
Private wealth advisers have long wanted to make alternative asset classes such as private equity and debt, real estate, infrastructure and commodities available to their clients to enhance portfolio strategy. Alternative investments can be an important part of a well-diversified portfolio, and there are more offerings and structures than ever before.
Access has always been a challenge, and certain products and strategies have typically been so laden with fees and structural flaws that they have made them unpopular or ineffective.
The search for a better mousetrap continued, as demand from advisors grew. Investing with the right fund managers is essential, as the marked difference between the returns of top quartile funds and those of the remaining universe of alternative managers is well documented. But access to the best institutional managers is traditionally a privilege reserved for the wealthiest.
This may change. More direct and profitable entry points for these managers are opening up. A growing number of advisers are finding that one of the easiest and most effective ways to access these managers is to partner with independent third-party platforms that can provide access to flagship funds from leading institutional managers in a very tactile and customer-centric environment. way.
Liquid Alts: Lost in Translation
These platforms avoid many of the barriers that have long blocked wider access to alternatives. In the mid to late 2000s, funds of funds became a common way for advisors to gain exposure to top managers. Unfortunately, the fee pressures and poor hedge fund performance that emerged from the Great Financial Crisis hurt those funds of hedge funds, and today the industry is a fraction of what it was. was. Additionally, technological improvements have made it possible to implement more hedge fund strategies in the liquid alternative space within a mutual fund structure. However, liquidity and short disclosure requirements and restrictions on private equity have limited the effectiveness of buying these deals compared to private partnerships.
One of the biggest complaints about alternative investment partnerships is the fee structure. Unlike a mutual fund where the sponsor typically receives a management fee, performance-based carry or incentive fees are very common for alternative investment strategies, increasing the overall cost to investors. Alternative strategies are usually more expensive, so accessing top-tier managers is paramount to justifying those costs. Additionally, fees will hurt the alpha generation that allows these managers to outperform their peers. For example, large distribution companies often add high platform fees and access costs to the fees of the hedge fund manager. These factors can have a significant impact on the internal rate of return and multiple of invested capital that an advisor’s client receives, especially compared to institutional investors.
Due to some of these cost nuances, we have seen an evolution within the alternative investment industry. Many major alternative investment brands are looking for ways to reach high net worth (“HNW”) clients, so many independent investment platforms have entered the market. As a result, more and more fund sponsors are offering takeover bids or interval fund structures to give retail investors direct access to their strategies. While these structures can provide entry points for some of the best known and most respected managers in the industry, advisors should be aware of the multiple limitations of these types of funds.
Liquidity: characteristic or defect?
Although interval funds allow greater access to alternative managers, there are opportunity costs associated with their use. One of the main performance drivers for many alternative strategies is the illiquidity premium they generate. The illiquidity premium can prevent investors from withdrawing capital from the markets at the wrong time, especially in times of stress and overzealous selling. Having the ability to withstand more market noise has been essential for many hedge fund managers to have more permanent capital that they can allocate to market stress while other fund managers are forced to sell for deal with redemptions. An interesting aspect of these takeover or interval funds is that they often allow for more liquidity than typical alternative structures, while maintaining similar investment mandates. The additional liquidity may come at a cost compared to a private partnership. Since interval funds are required to hold cash for weeks around their quarterly payment dates, they will be less invested compared to a similar partnership offering. This available liquidity will likely cause the performance of the interval fund to lag. Thus, there is less illiquidity premium available to these types of funds if they are forced to sell in a stressed market during these liquidity windows. Registration and compliance requirements also create additional costs for these types of funds compared to partnership offerings.