Although liquid absolute return funds (LARFs) have become increasingly popular, their track record compared with that of competing investments is mixed. LARFs have performed better than their hedge fund counterparts on several metrics. But they have higher fees than traditional equity and hybrid funds, and their performance has been disappointing during market downturns.
Unlike such alternatives as traditional hedge funds, liquid alternatives provide enhanced—most often daily—liquidity for investors. The author provides an overview of liquid absolute return funds (LARFs) and analyzes their risk–return characteristics compared with those of other popular funds. The results are mixed. Although LARFs achieve higher returns and are less volatile than traditional hedge funds, LARF performance during stock market downturns has been disappointing. In addition, LARFs charge lower fees than hedge funds, but their fees are higher than those of traditional equity and hybrid funds.
The author goes on to analyze the drivers of LARF returns and also demonstrates the limited diversification benefits that LARFs provide when added to traditional portfolios.
How Is This Research Useful to Practitioners?
Hedge funds have grown at a 15% cumulative rate annually since 1994 and currently manage an estimated $2.8 trillion. Until recently, these investments have only been accessible to institutional and high-net-worth investors. Now, given recent regulatory changes, retail investors have increasing access to such hedge fund–like investment strategies as LARFs. Against this backdrop, financial professionals would be well served to understand these vehicles.
Compared with hedge funds, LARFs achieve higher returns while exhibiting less skewness and kurtosis. In addition, they charge lower fees (a median total expense ratio of 1.75% versus 3.43% for hedge funds). But LARFs have experienced significant declines that tend to coincide with downturns in both equity markets and hedge funds. In addition, LARFs charge higher fees than traditional equity and hybrid funds.
The variation in the return performance achieved by LARFs can be explained by such drivers as equity market risk and the size and value premiums. In addition, changes in 10-year US Treasury yields, the US dollar, and commodity prices are important drivers (i.e., lower yields, a weaker dollar, and higher commodity prices imply higher returns). Momentum effects are generally not statistically significant.
LARFs have not enhanced the risk–return trade-off when added to a diversified portfolio. For example, when a LARF fund is combined with a 60/40 stock/bond portfolio, neither absolute nor risk-adjusted returns are improved.
How Did the Author Conduct This Research?
Using Bloomberg data, the author analyzes month-end net asset values of 1,105 funds with a total of 2,046 share classes globally. The Lipper database is used to collect total expense ratio data when available. Given that LARFs are relatively new, the average fund track record is relatively short at 56.6 months (with the median being 45 months). Only 102 of the 1,105 funds in the dataset have a track record of longer than 10 years. The assets under management range from $0.2 million to $38 billion. The 50 largest funds in the author’s database account for 67% of the total assets under management.
For the analysis, the author calculates a liquid absolute return index (LARI), which is composed of all of the funds in his database. This index is calculated on both an equal- and asset-weighted basis with monthly rebalancing. The LARI differs from hedge fund indexes in that LARI funds are both liquid and open for investments, whereas many hedge fund index funds are not.
To explain fund returns, a four-factor model is used with the three Fama–French factors and a momentum factor. Because LARFs and hedge funds are not constrained to only equity investments, a nine-factor model is also used to determine the influence of nonequity factors on the LARF returns. From these regressions, the author draws conclusions about the risk–return benefits of adding LARFs to portfolios.
The author shows that although LARFs are more attractive than hedge funds on several metrics, their higher fees compared with those of traditional funds and their poor performance during market downturns are concerning.
A potential limitation of the study is that LARFs are fairly new, and therefore, the data history is limited. In addition, the author’s LARF indexes suffer from survivorship bias because only funds that are still in existence are included in the analysis. As a final point, the author’s analysis focuses on the performance of LARFs in aggregate. The investment industry would benefit from future research that analyzes the different categories of liquid absolute return strategies.