Liquid alternatives have lost some luster but remain an attractive way to spread investment risk
Liquid alternatives regained popularity during the Covid-19 pandemic. Renewed interest from retail and institutional investors reflects recognition of the role liquid alts can play in helping to diversify risk in a volatile market. 2021 saw unprecedented demand for liquid alts; nearly all Morningstar categories benefited from positive net flows (with 33% increase in assets) and positive performance.
Originally designed to shield portfolios from the effects of stock market tumbles, in practice liquid alts have reduced the impact of investment profits and their returns have in recent years been disappointing when compared to traditional market benchmarks. However, with the market environment changing, now might be the time for these strategies to show their worth.
So what are liquid alts and why do they remain popular, despite some high-profile hiccups? To answer the first part of this question, we can split the phrase into its constituent parts:
- Liquid – providing daily liquidity (as opposed to some alternative investments which can have lengthy redemption periods)
- Alternative – invested in something other than traditional long-only equity and bond markets and therefore providing returns which are not dependent on the performance of those markets.
It is easy to see the attraction of this combination of absolute returns and liquidity in a structure which is more transparent and more highly regulated than a hedge fund, providing as it does diversification and downside protection to a portfolio whilst offering the regulatory oversights and accessibility of a more regulated fund structure (’40 Act or UCITS).
The continuing growth of liquid alts means that now, more than ever, the worlds of mutual and alternative funds are overlapping. This presents new challenges to the fund administrator who may wish to set themselves up to handle the complexities of these new hybrid investment vehicles. For the administrator who can provide this service, the market potential is considerable.
For any fund administrator, being prepared for liquid alts means addressing specific areas of process and functionality to verify that they have sufficient robustness to handle these requirements alongside existing business.
Technology can be an enabling factor here, providing it is sufficiently flexible and scalable. Is your technology up to the job? These are five key capabilities you should consider if your business handles or plans to handle liquid alts:
Handle a wide range of asset types
Is your system capable of handling the diverse range of asset types present in liquid alts? Liquid alts may include derivatives and other non-traditional holdings which you need to be able to process through your system. In addition, you may need to be able to handle simultaneous long and short positions.
Process for daily, weekly and/or monthly cycles
Typically, alternative structures were valued on a monthly basis (with some valuing weekly) whereas traditional funds tended to value daily. Now with the blurring of the lines between the two, alternative managers operating in the liquid alts space will need to value more frequently. You need to be confident that you can handle the various different valuation frequencies that will arise.
This Q&A with Gary is adapted from an interview which appeared in the Fund Technology, Data & Operations, North America 2021 report.
Support both traditional and alternative capital flows
In the traditional world there was always a strict T+X settlement period whereas in the alternative space you settled on a ‘cleared funds’ basis. The advent of liquid alts means that managers have to offer a defined settlement period. You need to ensure your system can support all types of settlement cycles, including redemption ‘hold backs’.
Be responsive to the various different types of regulatory oversight
You need to have the infrastructure in place to support a wider variety of regulations. For example, in the US you may have funds registered under the Investment Company Act of 1940, as well as alternative funds subject to the Dodd-Frank Act and other regulatory bodies such as the CFTC. In Europe, this equates to being compliant with both UCITS and AIFMD regulations. Your software needs to be sufficiently flexible to adapt quickly to changes in legislation from many different bodies with a correspondingly flexible reporting engine.
Simultaneously manage standard ’40 Act structures and more complex alternate investment strategies
Whether you’re coming at this with alternative experience or from the traditional side, liquid alternative funds will test your systems, processes, and procedures. From an alternative perspective, you’ll be taking on the regulations that go hand in hand with ’40 Act & UCITS funds. The increased reporting and daily valuations will require more robust systems. Straight-through processing right out to the end client will become key and increasing scale without commensurately increasing costs will be imperative. If you’re in the traditional space, embracing alternative strategies means deploying a system which can handle more complex fund structures and investor fee accounting, with multiple counterparties and the efficient tracking of cash flows.
Facilitate transparency with investor portals
Now more than ever, investors expect greater visibility into their portfolio. Millennial, ‘digital native’ investors are particularly noted for driving such expectations, but investors of all ages expect greater transparency, 24/7 access to information, and even the ability to trade. As a result, the demand for investor portals has grown significantly, particularly with the COVID-related lack of face-to-face customer interaction.
It seems that liquid alts are here to stay. Not only is this a market set for continued growth, according to predictions from both market commentators and participants, but it is also likely to become an investment mainstay. As such, administrators – both TPA and in-house – should be prepared. This includes devising a technology strategy which puts in place systems capable of managing these funds effectively, alongside other investments. Firms who are ready will be in a strong position to capture a share of this growth market.
About the author, Michael Galvin
Michael Galvin is Global Product Manager for Linedata’s fund accounting platforms. With 25 years in the industry, he has led the development of core applications, surround technology, and process management solutions for fund administration and investment management firms. Michael began his career as a fund accountant at JPMorgan Chase.