Note: This column was originally published on July 17, 2018.
Once, I was skeptical of “liquid alternatives”–mutual funds (and exchange-traded funds) that emulate hedge funds. Such funds talked big but walked small. I pointed to their lackluster returns and questioned whether their fortunes could change.
No need to question any longer. As Morningstar’s Jason Kephart and Kathryn Wing pointed out in “Death Is a Way of Life for Liquid Alternatives” (the headline leaves me jealous), liquid alternatives funds are quitting this world. The fund category that is terminating its funds at the highest rate, either through merger or liquidation, is a liquid alternative (managed futures). So is the second-place category, and the third-place category, and the fourth-place category.
If the fund companies that sponsor liquid alternatives funds admit through their actions to their failure, who am I to argue? That debate is over. Now is time for the postmortem.
The biggest problem that mutual funds face in attempting to be hedge funds is that these days, even hedge funds can’t be hedge funds. Although it is difficult to state with precision how the hedge fund industry has ever performed, given that hedge funds self-report their results (which means that no database can be either fully accurate or complete), it is pretty clear that through the early 2000s most hedge funds were good. They found niches that they could exploit.
Those niches disappeared as money flooded into the business. To cite a simple example, hedge fund managers once generated steady gains by purchasing a company’s convertible security, while shorting its common stock. As convertibles tended to trade at a lower price than did the company’s equity, that long-short transaction yielded an arbitrage profit. But the tactic did not permit much scale. Once convertible-arbitrage funds became popular, their gains disappeared.
Once their generic strategies disappeared, hedge fund managers were forced to change their ways. No longer could they succeed by making a trade that was common within their field (although uncommon outside of it). Now they had to think for themselves. To win, they had to become special. Unfortunately, few investors, even among the best-paid of portfolio managers, can accomplish that feat. Over the past 15 years, hedge fund performance has slipped.
Another way of viewing the matter: The hedge fund tracker HFR lists 7,000 existing funds in its database–and more than 18,000 that have expired. The odds against selecting a hedge fund that continues in existence (or, at the least, continues to report to a database) and that also posts above-average results are steep indeed!
(This commentary by AQR’s Cliff Asness addresses the topic in more detail. While bemoaning those who conclude that hedge funds have disappointed because they haven’t been able to keep pace with a roaring stock bull market–an argument that I do not make–Asness concludes that “the hedge fund world [is] becoming less different, and perhaps less special.”)
It’s the Culture
Even if hedge funds were to regain their mojo, however, mutual funds would struggle to mirror that success. One reason would be structural. The Investment Company Act of 1940, which covers publicly registered funds, does not permit high leverage. This restriction can often be worked around, by investing in derivatives that have implied rather than explicit leverage, but there’s no doubt that it does hamper some mutual fund activities.
Perhaps the greater impediment is culture. As Miriam Sjoblom, formerly of Morningstar, points out, those who run nontraditional-bond funds–the closest thing that the mutual fund industry offers to fixed-income hedge funds–typically began their careers running traditional portfolios. They are bond managers who are shifting to alternatives. Whereas with credit or global-macro hedge funds, the reverse holds true. They tend to be run by alternatives managers who are using bonds.
Of course, there is no proof that one career path is superior to the other. But there is no doubt that the mindset for investing traditionally differs from that of the alternatives manager. Traditional portfolio managers think almost exclusively about what is attractive–that which might be purchased. Managers who use alternatives strategies, though, care as much about the ugly as they do the beautiful. It is not enough for them to determine that an investment is overvalued; they must consider how deeply it is overvalued, in case they wish to short it.
Finally, there is the matter of compensation. Successful mutual fund managers become rich. They own large homes in Back Bay, condominiums in Jackson Hole and Palm Beach, and luxury boxes at Fenway. Successful hedge fund managers, on the other hand, own Fenway. They can make in a year what a top mutual fund manager earns in a lifetime.
Many regard salaries as the main reason why mutual funds can’t be hedge funds. Those who pay the best attract the best, they argue. Often, that holds true. For example, there is no question that the NBA hires the world’s best basketball players and then pays them roughly according to their abilities. But basketball abilities can be judged much more readily than can portfolio manager skills, and the basketball industry is more tightly controlled (the NBA being, effectively, single entity) than is money management. The two fields are not comparable.
In addition, the mutual fund industry’s lower salaries permit it to undersell hedge funds. While there are some exceptions, most liquid alternatives funds have lower overall expense ratios (considering performance fees in addition to standard management fees) than do hedge funds. We do not know how compensation affects manager quality–but we do know how fund expenses work. Every dollar that leaves the fund is one dollar less for its shareholders.
The two factors do not necessarily cancel each other out. It may be mutual funds’ talent loss exceeds the benefit of its reduced costs. Or, perhaps, it is the other way around. The net effect of the discrepancy in compensation remains unsettled. What is not debatable is that it amounts to one more difference between hedge funds and their publicly registered rivals.
In summary, today’s hedge funds do not live up to their past reputation. They likely will not until the industry suffers a major shakeout, so that it sheds most of its assets. Should that happy event occur, hedge funds should improve. So, too, will liquid alternatives funds. But for various reasons, they will not keep up with the genuine article.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.