Morningstar - Q2 2023 - 41

My purpose here is not to evaluate liquid alts
as a general matter, but to consider their
suitability for investors with $1 million to $10
million, often called high-net-worth individuals.
In this range, significant capital losses in
part of the portfolio can threaten the investor's
ability to retire. Preparing for retirement is,
of course, the primary reason that people in that
wealth range save and invest.
Investors in higher brackets may still find my
comments helpful, although they are less
limited in their choices. In particular, ultra-highnet-worth
investors, sometimes with $30 million
or more, are more like institutional investors
in their skill sets and ability to bear risk. It
is reasonable for them to consider both liquid
and illiquid alternatives as options.
The Endowment Model
In the past, I've been a vocal supporter of the
endowment model for large perpetual institutions.
Do I believe my own prior words? I do.
High-net-worth individuals preparing for
retirement are very different from large perpetual
institutions. My background is as an institutional
investor. I worked for 15 years at the Ford
Foundation, which was an early adopter of private
equity and a later adopter of hedge funds.
It has held real estate for almost the entire life
of the organization.
At Ford, I learned enough about the endowment
model, most eloquently described by
the late Yale CIO David Swensen, to defend
it against its many attackers.4
My defense
has appeared in a public and sometimes
testy print debate in 2021 with the esteemed
consultant Richard Ennis, who advocated
only indexing.5
What criteria do institutions or wealthy
individuals need to satisfy for the endowment
model to make sense? They need to have:
gSophisticated investment staff that is large
enough to include some experienced specialists
in alternatives investing.
gLong investment horizon.
gHigh degree of risk tolerance (the ability to incur
losses), at least in some part of the portfolio.
gThe ability to earn new money, attract donations,
or cut expenses if investments underperform.
gSufficient asset size to build a diversified portfolio.
Be aware that most alternatives, liquid or illiquid,
that are available to high-net-worth investors
involve high explicit fees and often high additional
hidden fees; unfamiliar risks, such as crowdedtrade,
counterparty, and short-squeeze risks; and
liquidity that is less than hoped for or advertised.
If you're not scared yet, you should be.
In addition, all liquid alts are active management
in some form, an actively managed investment
being anything that is not a broad market
index fund. The usual caveats about active
management rarely beating index funds in the
long run apply.
Performance, Risk, and Diversification Potential
Rekenthaler began his analysis as follows:
" Almost all liquid alternatives funds are new,
created after the 2008 global financial crisis. They
were, quite literally, an afterthought-a reaction
to the stock market's tumble. The pitch: These
funds would protect everyday investors' portfolios,
just as hedge funds did for institutions and
wealthy individuals. "
It is not a big surprise that a protective or
countercyclical product introduced after and
because of the stock market's previous
" tumble " -an understatement because it was the
worst bear market since the Great Depression-
might struggle to compete with the unexpectedly
vigorous market recovery that started in
2009. A hedged product is not supposed to match,
much less beat, a nearly straight-up stock
market. What we need to know is: Are liquid
alternatives an effective diversifier against
traditional investment (stock and bond market)
EXHIBIT 1
Summary Statistics of Long-Term Returns on Liquid Alternatives by
Morningstar Category
10-Year Compound
Equity Market Neutral
Event-Driven
Macro Trading
Multistrategy
Options Trading
Relative Value Arbitrage
Systematic Trend
Source: Morningstar. Data as of May 31, 2021.
Annual Total Return (%)
0.33
4.16
2.23
2.47
4.17
4.16
0.13
3-Year Standard
Deviation (%)
7.33
7.02
7.63
7.77
10.68
6.09
10.01
3-Year Equity
Market Beta
0.04
0.28
0.26
0.31
0.43
0.24
0.07
4 See, for example: Swensen, D.F. 2000. Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. Simon & Schuster. Second edition, 2009.
5 Siegel, L.B. 2021a. " Don't Give Up the Ship: The Future of the Endowment Model. " Journal of Portfolio Management Investment Models 2021, Vol. 47, Issue 5, PP. 144-149; Siegel, L.B. 2021b.
" The Endowment Model Is Just Active Management. " The Journal of Investing, Vol. 30, Issue 5 (August). PP. 8-13; Siegel, L.B. 2021c. " The Market Portfolio Is Bigger Than You Think. "
The Journal of Investing, Vol. 30, Issue 5 (August), PP. 21-26.
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