Are Hedge Funds Superior to Liquid Alts?

Are Hedge Funds Superior to Liquid Alts?Alternative mutual funds have several advantages over hedge funds that employ the same strategies: They’re more liquid, they’re more transparent, and they have lower fees. For retail investors that fall short of the “accredited” threshold ($200,000 in annual income or $1 million in liquid assets), alternative mutual funds and ETFs may represent their only opportunity for accessing alternative strategies, since non-accredited investors are prohibited from investing in hedge funds.

Do these advantages enjoyed by liquid alternatives leave any room at all for hedge funds? Steben & Company answers that question with a resounding “Yes!” in its May 2016 Alternative Perspectives white paper: Do Hedge Funds Have An Edge Over Alternative Mutual Funds? The Case of Equity Long/Short Strategies.

Beta Comparisons

One of the most obvious advantages of liquid alts is their enhanced liquidity. Mutual funds can be bought or sold every day, and ETFs trade intraday, while hedge funds often have lockup periods and might only allow redemptions on a monthly or quarterly basis.

But one downside of this enhanced liquidity is that liquid alts must stick to more highly liquid investments and strategies. Steben & Company compared long/short equity mutual funds and hedge funds from the period ranging from January 1, 2013 to December 31, 2015, and found that the average long/short equity mutual fund had a beta (relative to the S&P 500) of 0.51, while the average long/short equity hedge fund had a beta of 0.28.

Three-Year Beta Comparison Long-Short Mutual vs Hedge Funds

As you can see from the image above, long/short equity mutual fund betas were mostly clustered between 0.3 and 0.9, while hedge funds were clustered between -0.5 and 0.3. Having low correlation to the S&P 500 is normally a sought-after feature of long/short equity funds, so liquid alternatives definitely look less attractive on this basis.

Alpha Comparisons

While lower fees are another obvious advantage enjoyed by liquid alts, investors must also consider the not-so-obvious cost of those lower fees. Since liquid alts are prohibited from rewarding managers with performance fees, this potentially leads to an inferior set of liquid alts managers, relative to hedge fund managers. Why would a top-notch long/short manager earning 20% of profits from his affluent hedge-fund investors want to take the pay cut to manage a liquid version of his fund?

Three-Year Alpha Comparison Long-Short Mutual vs Hedge Funds

As you can see in the image above, hedge-fund managers generated much higher alpha for the three-year period ending December 31, 2015. Indeed, alternative mutual fund managers of long/short equity actually generated -1.10% alpha for the period, and their overall returns were boosted by high correlation to the S&P 500 during a bull market. Long/short equity hedge funds, by contrast, generated median alpha of +2.81%.

Managed Futures Exception

While Steben & Company’s empirical analysis suggests that long/short equity hedge-fund managers outperform their liquid-alternative counterparts, the same may not be true of managed futures managers. The futures market is highly liquid already, allowing mutual funds to close the performance gap with their hedge-fund counterparts. The lower fees charged by liquid alternatives compared to hedge funds may benefit net returns, in Steben & Company’s view.

For more information, download a pdf copy of the whitepaper.

Past performance does not necessarily predict future results.
Jason Seagraves contributed to this article.