Liquid Alternatives Aren't Watered Down

Liquid alternative mutual funds have garnered plenty of attention, both positive and negative, since they started proliferating in the aftermath of the financial crisis. One thing that is potentially misunderstood about the funds is just how well they can deliver similar returns as hedge funds given the extra constraints of the mutual fund structure, particularly liquidity and leverage, compared with less-regulated hedge funds. Three multistrategy alternative mutual fund managers tackled the question at the 27th annual Morningstar Investment Conference in Chicago on Thursday.

"The vast majority of hedge fund strategies can be run in mutual funds with little or no tracking error in a mutual fund," said David Kupperman, co-portfolio manager of Neutral-rated

Ronen Israel, co-portfolio manager of Neutral-rated

"You can achieve the same leverage and same volatility in mutual funds as hedge funds, you just have to be a little bit more creative," Israel said. "At the end of the day, mutual funds can deliver the same returns institutional investors have received from hedge funds for years."

Even if there is some tracking error between a liquid mutual fund strategy and a less-liquid hedge fund strategy, that difference could potentially be wiped out by the lower fees in the mutual fund. Unlike hedge funds, which have historically charged 2% management fees and 20% performance fees, mutual funds don't charge similar performance fees.

Not all hedge fund strategies work in a mutual fund format, though. Strategies such as distressed credit or activist investing, which are inherently less liquid, don't work as well in a vehicle like a mutual fund, which is required to provide daily liquidity to shareholders.

Multi-strategy alternative mutual funds have been among the most popular fund categories this year. Funds in Morningstar's multialternative category have received $6.37 billion of net inflows year-to-date through the end of May, the most of any alternative fund category.

The three managers also shed light on the role they see these funds play in a portfolio.

When creating Bronze-rated

Diversification is indeed the primary purpose of multistrategy funds, AQR's Israel said. "A traditional portfolio is dominated by equity market risk. We're looking to harvest uncorrelated sources of return that aren't driven by equity market or interest rate risk. These alternative strategies have the same economic intuition that traditional sources of return might have. There are reasons why they exist and reasons why we believe they are going to continue to exist in the future."