In the current risk-averse investment environment, liquid alternatives, or hedge fund strategies in mutual fund form, provide a distinct opportunity for investment return and dampening of overall portfolio volatility. David Kupperman, a Managing Director with Neuberger Berman and a senior member of the investment team for Neuberger Berman Absolute Return Multi-Manager Fund, discusses the appeal of “liquid alts” and the emerging subcategory of multi-manager alternative funds.
Investors have recently faced a perfect storm in seeking to achieve their long-term financial goals. Nearly five years after the world-changing financial crisis began in 2008, markets continue to experience episodic, extreme bouts of volatility, most recently related to fears over sovereign debt in Europe. The net result has been continued risk aversion among investors and more cash on the sidelines. The situation is exacerbated by meager yields of bonds, which investors might otherwise look to for a source of meaningful return.
Given the nature of this challenging environment, advisors may wish to think creatively in trying to solve the challenges faced by their clients. “Liquid alternative” investments, or hedge fund strategies available in ’40 Act mutual funds, are worth considering as a viable way to introduce the lower correlations and lower volatility of hedge fund strategies to mainstream clients.
Access to alternatives, of course, has been historically limited to institutions and the very wealthy who could meet steep investment minimums and the definition of “accredited investor.” But with the advent of liquid alternatives, the doors have opened wide to the mainstream.
Such funds offer all of the investment benefits of hedge funds—reduced correlations to major asset classes, the ability to benefit from manager skill, and lower volatility—but also provide the advantages of mutual funds, including transparency, daily liquidity and limitations on the use of leverage.
As a result, the reception among investors has been enthusiastic. Since 2008, the alternatives mutual fund sector has grown by nearly 40% annually on a compounded basis. As of March 31, 2012, the category had more than 400 funds, with $354 billion in AUM or roughly 4% of mutual fund assets industry-wide (Source: Simfund data as of 3/31/2012).
Now, a relatively new subcategory of alternatives of funds is set to emerge as well—multi-manager alternative mutual funds—which we believe could have significant potential as a portfolio tool for advisors and their clients.
For background on their appeal, let’s take another look at the traditional alternatives industry. Among hedge funds, performance dispersion is common—a function of varying styles but, even more important, the close relationship between manager skill to investment success. As a result, pension funds, endowments and other sophisticated investors routinely look to funds of hedge funds as a means to vet underlying managers and diversify across strategies.
Turning to mutual funds, liquid alternative multi-manager portfolios can serve an analogous, highly valuable function for financial advisors who want to access alternative strategies for their clients. Leveraging the primary manager’s industry expertise, experience and contacts, multi-manager funds can select a range of quality strategies that complement one another and have the potential for favorable risk-adjusted returns.
Currently, advisors may be apt to select and recommend one or two alternative funds themselves—an approach that fails to capture the true diversification benefits of the asset class. Or they may try to construct a more complete portfolio of the strategies, which can prove overwhelming and potentially risky. In other words, quality multi-manager funds provide a real advance for the industry.
Why has it taken so long for multi-manager funds to “come of age”? Until recently, many hedge fund managers were reluctant to serve as mutual fund sub-advisors, but since 2008 the hedge fund business has changed. Asset flows have benefited the largest of managers. In 2011, of the approximately net $70 billion raised, about $50 billion went to managers with assets greater than $5 billion, representing roughly 5% of firms, while the remaining 95% saw net flows of roughly $20 billion in aggregate (Source: HFR Global Hedge Fund Industry Report – Year End 2011-2012). This group—including many well-respected, seasoned investors—is now looking for new partners to expand capacity. There are many sub-$5 billion hedge fund managers who are great investors with long careers investing successfully through cycles. In addition, with the growth of the defined contribution space (i.e. 401(k) plans), hedge fund managers are appreciating the potential benefit of offering alternative mutual funds to gain access to that growing space.
Moreover, as sophisticated investors have required more transparency from hedge funds, including the use of outside “risk aggregators” that provide position-level disclosure, managers have become used to close scrutiny and openness, making operating in a mutual fund more acceptable.
Finally, hedge fund managers have become more educated about the rules associated with mutual funds and understand that they can successfully execute their strategies in the context of the ’40 Act. Yes, more stringent leverage limits apply, which rules out the use of certain highly levered strategies such as statistical arbitrage. And portfolio holdings must be liquid and available for sale on a daily basis, eliminating certain distressed investments that require extended periods to mature. But the majority of hedge fund strategies—long / short equity, credit arbitrage, risk arbitrage, event driven, macro, to name a few—fit nicely into ’40 Act funds.
Does this mean we will see a rush of multi-manager funds to market? The opportunity is certainly there. Investors are under-confident about traditional asset classes, and eager for different sources of return. And advisors can employ them to provide a whole new layer of portfolio construction for their clients.
But building a multi-manager fund involves a high level of complexity. Identifying quality sub-advisors, conducting due diligence, portfolio construction, building oversight systems for both operations and risk management—all take experience and skill, and represent a very steep learning curve for those who are not already well-versed in both the hedge funds and mutual funds businesses. It’s therefore unclear how many investment firms can step up to the plate in this area and deliver quality funds.
Assuming that more funds are launched, financial advisors must do their homework—and only when they are comfortable with the investment approach, experience and reputation of a provider should they take the plunge into this potentially important segment of the mutual fund landscape.
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The Fund’s performance will largely depend on the success of Neuberger Berman’s methodology in allocating the Fund’s assets to subadvisors, and its selection and oversight of the subadvisors. The subadvisors’ investment styles may not always be complementary, which could adversely affect the performance of the Fund. Some subadvisors have little experience managing registered investment companies which, unlike the hedge funds these managers have been managing, are subject to daily inflows and outflows of investor cash and are subject to certain legal and tax-related restrictions on their investments and operations.
The Fund’s returns may deviate from overall market returns to a greater degree than other mutual funds that do not employ an absolute return focus. Thus, the Fund might not benefit as much as funds following other strategies during periods of strong market performance. Also, the employment of hedging strategies, if any, in an attempt to mitigate risk may cause the Fund’s returns to be lower than if hedging had not been employed.
Event-Driven Strategies that invest in companies in anticipation of an event carry the risk that the event may not happen or may take considerable time to unfold, it may happen in modified or conditional form, or the market may react differently than expected to the event, in which case the Fund may experience losses. Additionally, event-driven strategies may fail if adequate information about the event is not obtained or such information is not properly analyzed. The actions of other market participants may also disrupt the events on which event driven strategies depend. Arbitrage Strategies involve the risk that underlying relationships between securities in which investment positions are taken may change in an adverse manner or in a manner not anticipated, in which case the Fund may realize losses. The Fund’s use of event-driven and arbitrage strategies will cause it to invest in actual or anticipated special situations—i.e., acquisitions, spin-offs, reorganizations and liquidations, tender offers and bankruptcies. These transactions may not be completed as anticipated or may take an excessive amount of time to be completed. They may also be completed on different terms than the subadvisor anticipates, resulting in a loss to the Fund. Some special situations are sufficiently uncertain that the Fund may lose its entire investment in the situation.
Stock markets are volatile and may decline significantly in response to adverse issuer, political, regulatory, market or economic developments. To the extent that the fund sells stocks before they reach their market peak, it may miss out on opportunities for higher performance. Small- and mid-capitalization stocks trade less frequently and in lower volume than larger company stocks and thus may be more volatile and more vulnerable to financial and other risks.
Investing in foreign securities may involve greater risks than investing in securities of U.S. issuers, such as currency fluctuations, potential social, political or economic instability, restrictions on foreign investors, less stringent regulation and less market liquidity. Securities issued in emerging market countries may be more volatile and less liquid than securities issued in foreign countries with more developed economies or markets as such governments may be less stable and more likely to impose capital controls as well as impose additional taxes and liquidity restrictions. Exchange rate exposure and currency fluctuations could erase or augment investment results. Funds may hedge currency risks when available though the hedging instruments may not always perform as expected. Derivatives contracts on non-U.S. currencies are subject to exchange rate movements. The risks involved in seeking capital appreciation from investments primarily in companies based outside the United States are set forth in the prospectus. Shares in a fund may fluctuate based on interest rates, market condition, credit quality and other factors. In a rising interest rate environment, the value of a fund’s fixed-income investments is likely to fall.
Derivatives may involve risks different from, or greater than, those associated with more traditional investments. Investments in the over-the-counter (“OTC”) market introduces counterparty risk due to the possibility that the dealer providing the derivative may fail to timely satisfy its obligations. Investments in the futures markets also introduce the risk that its futures commission merchant (“FCM”) may default on its obligations including the FCM’s obligation to return margin posted in connection with a fund’s futures contracts. Short sales, selling a security a fund does not own in anticipation that the security’s price will decline, theoretically presents unlimited risk on an individual stock basis, since a fund may be required to buy the security sold short at a time when the security has appreciated in value. Leverage may amplify changes in a fund’s net asset value. ETFs are subject to tracking error and may be unable to sell poorly performing stocks that are included in their index. ETFs may trade in the secondary market at prices below the value of their underlying portfolios and may not be liquid. The use of options involves investment strategies and risks different from those associated with ordinary securities transactions. A “covered call” involves selling a call option while simultaneously holding an equivalent position in the underlying security. A put option involves buying the right to sell a security at a specific price within a given time period.
Several of the strategies utilized by the Fund may engage in frequent and active trading and have a high portfolio turnover rate, which may increase the Fund’s transaction costs, may adversely affect the Fund’s performance or may generate a greater amount of capital gain distributions to shareholders than if the Fund had a low portfolio turnover rate.
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