Liquid-Alternatives and Diversification: Is There a Better Way?

Especially for investors whose main exposure to the markets began with the  bull market of 2009–2020, the current persistent weak performance of many stock and bond investments may provoke a search for better alternatives. One source of such may be found with so-called liquid alternative, or “liquid-alt” investments, which seek to use various strategies to provide superior returns to more conventional approaches.

Liquid-alts, sometimes referred to as “40-Acts” because of their creation by the Investment Act of 1940, are typically available in the form of mutual funds or exchange-traded funds (ETFs). They hold similar assets to those held by other funds, such as stocks and bonds, but they engage in techniques such as short selling and trading on margin in order to increase the total return to their shareholders.

Growing from around twenty funds in 2006 to the present 120 or so that are currently available, liquid-alts would seem to be making strong gains in popularity. But how successful have they been during the last several years in delivering the above-average returns they aim for?

SOURCE: Dimensional Fund Advisors, Morningstar Fund Data. Past performance is no guarantee of future results; indexes are not available for direct investment.

In the 16-year period from June 2006 to June 2022, the average annualized return of liquid-alt funds has lagged most major equity and fixed-income indexes, as shown in the chart above. Only one-month Treasury bills failed to deliver superior rates of return during the period, and it’s important to note that the volatility of the liquid-alts was ten times that of one-month Treasuries—probably not enough of a return advantage to justify the added risk.

One factor in the relatively poor performance of liquid-alts is the high expenses and turnover associated with these funds. During the period shown above, their weighted average expense ratio was a hefty 1.58%, and the assets held by the funds turned over at the brisk clip of 187.2%.

There are really only two reasons for holding any asset in a portfolio: 1) higher expected returns, or 2) managing risk. Given the data above, it isn’t clear that liquid-alts meet either of these requirements for most investors. It is also not clear that liquid-alts offer substantial benefits of diversification, notwithstanding their stated goal of low correlation with traditional equity and fixed-income holdings. In fact, most liquid-alts start from the same place as other funds: stocks and bonds. Though they may attempt to de-link their returns from the characteristics of the broad markets, they are actually using the same building blocks.

For most investors seeking lower volatility and improved returns, strategic diversification offers a more cost-effective and better-performing alternative. By assembling a portfolio of domestic and global equities and fixed-income securities, investors may gain exposure to tens of thousands of securities across dozens of countries and various currencies. Those wishing to mitigate risk while pursuing superior expected returns should carefully consider the proven track record of a globally diversified portfolio.

As a fiduciary wealth advisor, Empyrion Wealth Management specializes in helping clients build diversified portfolios that are tailored to each individual’s long-term financial goals. To learn more, click here to read our white paper, “The Informed Investor.”

Stay Diversified, Stay YOUR Course!