Traditional investment managers are better positioned relative to alternative managers to meet retail investors' growing demands for liquid alternative investments (liquid alts), says Fitch Ratings.
The reasons include the experience and scale that traditional managers enjoy in fund distribution, combined with our expectation that many of the defining attributes of typical alternative products can become muted under the US mutual fund construct.
Despite these advantages for traditional managers, long-term success will hinge more on the balance between fund costs and product performance than manager type.
Fitch defines liquid alts as a form of investment that combines an open-end mutual fund with more sophisticated investment approaches such as shorting or leveraging, or investing in instruments such as options, futures, currencies, or commodities. The area represents one of the fastest growing sub-segments of the retail investment space.
While traditional and alternative managers have historically not directly competed for retail customers, liquid alts raise the potential to create that dynamic. Alternative managers eye retail customers not only to grow assets under management (AUM), but also to further diversify their investor bases. For traditional managers, liquid alts serve as a new, potentially higher fee product, whose performance can be less correlated with long-only equity and fixed-income funds.
Success in liquid alts involves business and reputational risks, as both traditional and alternative managers generally must develop an expertise apart from their core competencies. Traditional managers must expand their alternative product expertise and alternative managers must develop and maintain distribution channel and advisor relationships, as well as manage (or outsource) fund administration and reporting.
Importantly, alternative managers that enter the liquid alt sector must operate their funds under the Investment Company Act of 1940 (40 Act), which constrains portfolio managers' abilities with regard to leverage (through asset coverage tests), liquidity (85 per cent of securities must be in 'liquid' assets) and diversification (most funds must meet diversification tests for certain tax treatments). The constraints of the 40 Act can mute the very attributes that have contributed to many alternative managers' historical successes, Fitch says.
A number of alternative managers have successfully offered other investment products in the 40 Act space, such as through closed-end loan funds and business development companies, but relative to how many alternative managers invest, the restrictions of open-end mutual funds present challenges. Fitch believes that managers of liquid alts likely face more asset-liability challenges than in most long-only mutual funds.
On the distribution front, traditional managers have more established marketing frameworks and relationships with financial advisors and defined contribution (DC) administrators, allowing them to effectively position their product offerings.
The ability for individual investment managers to benefit from liquid alts will depend on how retail investors view the funds' performance and expense ratios, the latter of which can run in the one to two per cent range. It is likely that traditional managers, because of their larger scales and product offerings, will have greater ability to compete on price than many alternative managers. All liquid alt managers will ultimately need to justify that fund costs are worth achieving better levels of stability over periods of market downturns, a market test yet to be seen, Fitch says.
