Alts Democratized. Rabe Jessica Lynn

used by Lipper, and the definition emphasizes the investment strategy rather than the legal structure.

      The term hedge fund strategies includes a broad range of investment vehicles that operate in a different legal structure. Hedge funds are usually pooled vehicles with investments managed in a general partner/limited partner structure, and held by a limited liability company. These funds have fewer restrictions on the investment strategy, manager compensation, and public disclosures than do '40 Act investments.

      Traditional hedge funds are designed for accredited investors, and typically have high minimum investments, limited liquidity, and long lockup periods. Investors get K-1 statements that can make tax reporting difficult, and the paperwork and suitability requirements are demanding.

      When we mention “traditional alternatives,” this refers to single-manager hedge funds, fund-of-funds hedge funds, private equity, and privately held real estate. These traditional alternatives are usually available only to high-net-worth investors, and this gives wide latitude to hedge fund managers.

      In contrast, '40 Act investments are meant for the masses, and have strict regulatory requirements, including limits on leverage and illiquid assets. For example, '40 Act funds can have borrowings of no more than one-third of total assets, and this reduces their ability to replicate certain hedge fund strategies that rely on high leverage (credit arbitrage). Also, '40 Act investments limit holdings of illiquid assets and transactions with affiliated persons, which makes it difficult to participate in private equity strategies such as venture capital. And '40 Act funds have strict disclosure requirements about the positions they hold and the compensation paid to investment managers, and these disclosures are made through the filing of the prospectus, annual report, and statement of additional information. These funds usually offer daily liquidity to investors who seek redemptions, though this is not true for closed-end funds or interval funds. There are many other legal nuances that distinguish traditional and liquid alts, but the main differences involve fees, liquidity, transparency, and taxation.

      Today the lines between '40 Act funds and limited partnerships are blurring as traditional alternative fund managers enter the '40 Act space in search of broader distribution. The entrance of traditional alternative managers is leading to product innovation and a breadth of new choices for advisors and investors, and this requires new approaches to fund research and deeper levels of fund manager due diligence.

      Lipper Classifications

      This book uses Lipper classifications to define liquid alts, and these classifications exclude certain assets that some investors define as alternative. The Lipper classifications used in this book exclude real assets of all types – commodities, precious metals, master limited partnerships (MLPs), real estate investment trusts (REITs), privately held real estate, infrastructure investments, and Treasury Inflation-Protected Securities (TIPS). These securities are generally considered real assets in the framework used by institutional investors.

      The Future

      There is currently no industry standard for exactly what constitutes an “alternative” investment. The definition of liquid alts is continually evolving, and precise classifications are in the eye of the investor.

      The future of liquid alts is likely to include some form of private equity, such as leveraged buyouts, mezzanine financing, infrastructure, and venture capital. These are now difficult to package effectively in a '40 Act structure, but strong investor demand suggests that this is a large potential market for product providers that can innovate.

      The definition of liquid alts may also expand to include forms of so-called smart beta. Smart beta uses rules-based approaches to define factor exposures, such as indexes that are not weighted by market capitalization, but by equal weights or fundamental factors such as sales, profits, or price-to-book ratios. Smart beta also includes sophisticated algorithms for optimization, such as minimum variance, maximum diversification, and risk-efficient indexes.

      The factor exposures discussed in this book may overlap with some forms of smart beta. Chapter 7 discusses Alternative Equity Market Neutral Funds, and includes the PIMCO Fundamental Advantage Absolute Return Strategy Fund (PFATX). This fund has long exposure to a smart beta strategy, a fundamental equity index called the Enhanced Research Affiliates Fundamental Index (Enhanced RAFI 1000). PFATX also has a short exposure to the Standard & Poor's (S&P) 500 index, so the fund seeks to capture the return premium of an index that is weighted according to fundamentals over an index that is weighted according to market capitalization. This is an example where liquid alts and smart beta converge, and there is room for disagreement as to the demarcation between smart beta and liquid alternatives.

      Note: This book focuses on the track record of funds through year-end 2013. We occasionally note subsequent events, such as the departure of Bill Gross from PIMCO (see PFIUX in Chapter 9), and the downturn in returns at MainStay Marketfield (see MFLDX in Chapter 10). These events highlight the need for ongoing due diligence of liquid alternatives, especially for funds that give broad discretion to the portfolio manager.

      This book focuses on funds that Lipper classifies as alternative, and the underlying factor exposures of these funds. This provides a clear, functional, and comprehensive map of the liquid alts space. These classifications will continue to evolve, and may eventually include smart beta and private equity. The authors believe that the Lipper data provide a useful framework and functional tools for asset allocation and fund selection, and the Lipper classification methodology is among the most practical and accurate systems that are widely available at this point in time.

      Methodology

      This book is aimed at financial advisors and sophisticated investors and it assumes familiarity with basic investment concepts. It is meant to be a practical tool, so we stick with a simple framework and we disclose our key assumptions.

      How to Use This Book

      The chapters in this book can be read independently, and the authors intended each section to serve as a reference tool. Advisors are busy, and may want a quick overview of a classification and the funds in it. Advisors may choose to read the synopsis at the beginning of each chapter, just to get a feel for the key takeaways.

      The book does have a comprehensive framework for liquid alts that starts at the 10,000-foot level, and eventually offers granular detail about individual funds. Some advisors may be interested in only a road map for the alternatives space, and how the classifications fit into the investment landscape. Other advisors may want to understand the specific factor exposures and fund selection process for a given Lipper classification, in order to augment their existing due diligence process.

      We offer a framework as a guide, mainly to clarify our assumptions and prevent misunderstandings. We are not looking to either encourage or discourage the use of liquid alternatives, and we are not promoting one investment approach over another. We hope that clear definitions and a clearly articulated structure allow for a coherent discussion, even for advisors who operate with a different investment philosophy and a different set of assumptions. We may agree or disagree with other investors about the proper definition, purpose, and role of liquid alternatives. Our main goal is to provide a framework that is internally consistent, and that provides a springboard for advisors who want to put these products to work for their clients.

      Or perhaps an advisor will review the data and conclude that liquid alts are not worth their time and energy, given their clients' needs and their firm's resources.

      Illustrations, Not Recommendations

      This book offers a process for asset allocation and fund selection, and discusses specific ETFs and mutual funds. Any analysis or example in this book is for illustration purposes only, and is not an investment recommendation for any advisor or investor.

      All written content is for informational purposes only. Material presented is believed to be from reliable sources, but the authors make no representations as to its accuracy or completeness. Individual investors should discuss all information and ideas in this book in detail with their individual advisor prior to implementation. Investment advisors should note that their parent firm may strictly limit the use of certain funds described in this book. This is especially true for leveraged and inverse