“Be generous with your time and your resources and with giving credit and, especially, with your words. It’s so much easier to be a critic than a celebrator. Always remember there is a human being on the other end of every exchange and behind every cultural artifact being critiqued. To understand and be understood, those are among life’s greatest gifts, and every interaction is an opportunity to exchange them.” -Maria Popova (blogger/writer)
I’m not going to search the archives, but today’s quote must be the longest in Alt Blend’s long and storied history. I considered several other topics to cover today, but – as the topic of private credit continues to permeate headlines and daily conversations with colleagues and clients – it’s what we will (sort of) cover again today, although hopefully from angles we haven’t before. To the point of Ms. Popova’s lengthy insight, this will ideally come from a place of gratitude, appreciation for disagreement, and desire for greater understanding of private credit (and our fellow humans), but that first means we need to look to the past and bolster our collective Alts knowledge a bit. Here we go!
How did we even get here?
Rather than a strict history lesson, I’m going to lean more on my professional experience and the journey of clients I have personally advised. Prior to (roughly) a decade ago, the world of Alts and how they were accessed was much more limited and arduous. If you had the desire for Alts exposure, but were a person of “average” means, then your opportunity set consisted of “liquid alternatives.”
As the name implies, the main advantage of these strategies is that they are liquid – most often offered as run-of-the-mill mutual funds that can be bought and sold each day. And as the name also implies, the terrible part of these strategies is that they are liquid and can be bought and sold each day. It turns out that the potential need to meet unlimited daily redemptions really restricts what a fund can invest in. There’s No Free Lunch.
Good ol’ liquid alts?
Liquid Alts can typically be described as one or more of the following strategies:
- Long/Short (L/S) Equity: classic hedge fund strategies, which can both buy (long) and sell (short) stocks to help mitigate market risk while making bets on underlying companies. Most are “long biased,” where the longs outweigh the shorts, lacking the conviction to short the market outright (which is very risky, but keep in mind that they gained prominence when 2008 was still fresh in people’s minds, and the idea of a fund making money in the next big downturn to hedge overall portfolio risk sounded appealing). As you may expect, however, the “daily liquid mutual fund” wrapper limited both the positions and the amount of leverage that could be utilized. If you summed this up as “watered-down hedge fund,” I wouldn’t fault you for it. A subset of L/S funds is “Equity Market Neutral,” which “aims to isolate stock-specific risk by balancing long and short positions to eliminate market risk.”
- Global Macro: as the name implies, the goal here is to make money from big picture (macro) happenings throughout the world. If you’ve followed David Bahnsen for a while, then you’ve probably heard him discuss how no one knows what’s going to happen tomorrow or two weeks from now with an event like the current war in Iran; further, formulating a trade based on that unknowable event outcome is a fool’s errand. But that doesn’t stop Global Macro managers from trying! 😊
Seriously, though, even if there have been a select few very successful macro funds in history (there have), I can assure you they haven’t been delivered in a daily-liquid mutual fund wrapper. What you will most likely get is a fund touting many interesting ideas, expressed through both long and short positions (a lot of each), which will ultimately net out to a mediocre return stream. And while it may technically add “non-correlation” and have less volatility than bonds, the returns may be lower than those of your bonds, too.
- Managed Futures: as with the above, these can be long and short, paired, hedged, etc., but the positions are all futures contracts (e.g., currencies, commodities, interest rates, equity indexes). Back when I was utilizing some of them and following them more closely, the most popular ones employed “trend following,” so they performed very well when there were established trends (i.e., consistently rising or falling prices) to follow. I’ll let you guess how they did when there were no solid trends to follow. Late 2007 to early 2009 was enough of an extended downtrend in equities and other markets that it allowed trend-following funds to benefit from having substantial short exposure. Thus, they stood out as some of the lone positive performers in a vast sea of red, and that got people’s attention.
- Arbitrage / Event-Driven: these strategies aim to profit from events (they really are aptly named), especially mergers & acquisitions. A common subset is “merger arbitrage” (aka merger arb), which often involves going long the target company and shorting the acquirer. The interesting thing about event-driven strategies is that the trades can have a finite life with a clear endpoint. A merger eventually occurs (the event) or it doesn’t. This is my preferred area of Liquid Alts, as the various events and arb structures can be entirely idiosyncratic in their risk/reward and can often be implemented using liquid positions. In fact, back in 2021, we did a special audio-only “Credit Arbitrage Analyst Field Trip” to explore a credit arb strategy in more depth.
- Multi-Strat: a combination of the above strategies, but run by the same management company in a single fund; e.g., asset manager ABC runs the fund, but all of the underlying strategies are also in-house ABC teams.
- Fund of Funds (FoF): an assortment of different investment managers all contained within one fund; it could be all one type of strategy or different strategies. The FoF manager builds the structure and selects the managers/strategies and allocation. So, if asset manager ABC runs the fund of funds, the underlying holdings could be 5% GHI Merger Arb, 10% XYZ Managed Futures, 10% LMS Long-short Equity, etc.
As you can see, the lines between liquid alts strategies can get blurry, as they cover a spectrum of equities (indexes & individual stocks), bonds (indexes & individual bonds), equity/credit derivatives, futures, commodities, and currencies (and probably some other stuff), using long or short positions to express views and manage risk across global happenings, events, and/or specific companies…and then those approaches can get wrapped into other funds. There are a mind-numbing number of options. I have done my share of research and have incorporated Liquid Alts into past portfolios, and my general sentiment is that they often fail to deliver on expected outcomes. This is not to say none of them are useful, but it is important to ABS: always be selective.
In the spirit of objectivity, if you’d like a more pro-liquid-Alts perspective, then this overview from AQR is worth checking out.
The table has been set
We’re now out of time (aka space) for today’s edition, but we’ve set the table for more perspective on how those earlier liquid alts worked, and then I will express gratitude for how alternative access has continued to evolve from there.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
