Alternatives for the Masses?

On March 1, 2023, two corrections were made to this article. In the text accompanying Exhibit 3, Amy Arnott was included as a source for the data. In footnote 12, which pertains to Exhibit 4, a clarification was added based on input from Ben Johnson of Morningstar.

As a long-standing supporter of the “endowment model,” I’ve spent decades balancing my enthusiasm for active management and alternative investments against my theory- and evidence-based belief in indexing. But my advocacy of alternatives has been targeted to institutions and ultra-high net worth investors. The recent embrace of so-called liquid alternatives by ordinary Americans seeking to fund their retirement is deeply troubling.

I will start with a broad definition of alternative investments and describe their “liquid” manifestation. Next, I summarize the reasons why I’ve encouraged the most sophisticated investors to explore alternatives as potential enhancements to their portfolios. I then turn to the central question of whether that makes sense for those with less than $10 million in assets.

What are alternative investments?

A traditional investment is a publicly traded stock, bond, or money market instrument, or fund thereof, in any country in the world. Everything else is alternative.1

Alternatives, being an “all other” category, are very diverse. They run the gamut from the mundane (rental real estate) to the exotic (fine art, royalties, life settlements). Cryptocurrencies are alternative, although calling them investments is stretching a point.

Liquid alternatives

The alternative investments that have recently appealed to individual investors – and that have been pushed by some advisors – are liquid alternatives. These are otherwise illiquid strategies – primarily private equity, hedge funds, and real estate – that have been repackaged as mutual funds or ETFs so that they are tradeable daily on an exchange. Because of this repackaging, individuals can buy, hold, and sell them with modest amounts of money.2

In a fairly recent (July 2021) Morningstar paper, “Liquid Alternative Funds: Is There Any Hope?”, John Rekenthaler presented a classification scheme for liquid alternatives, used for organizing Morningstar’s reports on these funds. The fund categories, or investment styles, that are in the Morningstar liquid alts database are:

  • Equity market neutral
  • Event driven
  • Macro trading
  • Multistrategy
  • Options trading
  • Relative value arbitrage
  • Systematic trend

These strategies are all hedge fund-like. This article focuses only on the liquid-alt versions of these categories. Private equity, real estate, and exotics are excluded, making my analysis more manageable.