Morningstar - Q2 2023 - 44

Strategies
plummeting stock or bond market, but
it's not a win. A win for a diversifying
asset is a positive return when traditional
assets decline.
as of 2022, high-net-worth individuals had 26%
of their assets allocated to alternatives broadly
construed (not just liquid alts) and that the
percentage for ultra-high-net-worth individuals
was 50%.8
It's true that these percentages
Assets Under Management and Fund Flows
Do individuals have too much in liquid
alts? Are they continuing to invest, or are
they redeeming?
As of Nov. 30, 2022, U.S. liquid alts-to be
precise, alternative open-end mutual funds
and ETFs-had $183.66 billion in total net
assets, according to Morningstar Direct. That
sounds like a lot of money, but if the aggregate
value of U.S. liquid alts were a company,
it would be only the 52nd
-largest company in
the MSCI ACWI Index of global equities.
Liquid alts, thus, account for only 0.5% of total
mutual fund and ETF assets under management.
If this number is representative of what
individual investors hold, we don't have much
of a problem.
But other evidence suggests that we do have a
problem. The Motley Fool reported that,
count all alternatives, including directly held real
estate, direct hedge fund holdings, private
equity, commodities, and so forth, and that these
more venerable alternatives categories
are much larger slices of the capital markets
than liquid alts.
But how many investors with under $10 million,
preparing for retirement and getting investment
guidance from advisors, own significant
amounts of these old-style alternatives? Isn't it
more likely that they've followed advisors'
recommendations and bought liquid-alt shares,
which are easy to obtain and easy to follow
in mutual fund data sources?
To answer this question, I have to look at
anecdotal evidence, because no direct data is
available. Way back in 2015, Josh Charney
of Morningstar wrote:
EXHIBIT 3
Investors' (Dollar-Weighted) Returns
on Broad Categories of Mutual
Funds Compared With Returns on the
Funds Themselves (Time-Weighted),
2009-18, Annualized
Broad Category
Group
Allocation
Alternatives
Equity
Fixed Income
Source: Morningstar.
Investor
Return (%)
5.54
-2.05
6.25
3.39
Total
Return (%)
5.32
-0.61
6.82
3.95
Gap (%)
0.22
-1.44
-0.56
-0.55
" Most advisors (59%) allocate between 6% and
20% to alternatives.... [O]rganic growth
rates for liquid alternative mutual funds during
2014 are still larger than any other broad
Morningstar Category. " 9
As we'll soon see, fund flow data strongly
suggests that these numbers have either
remained stable or grown since 2014, rather
than shrinking.
With liquid alts making up only a fraction of total
fund assets but representing a considerable
chunk of advisor recommendations, it's
hard to avoid the conclusion that they have
become concentrated in portfolios-retirementfocused
high-net-worth portfolios guided by
advisors-that are owned by the investors least
equipped to understand the products,
handle the risks, and afford the fees. This is
supported by logic and the quantitative evidence
I've been able to gather. If it's true, highnet-worth
investors should hold much less in
liquid alts. Sometimes, I think they shouldn't have
any at all.
Fund Flows
Fund flows into and out of a category of
mutual fund or ETF provide information about
investor reaction to returns. It is widely
believed that investors buy assets that have
recently risen in value and sell assets that have
fallen, with the consequence that investor
performance is worse than the performance
of the assets themselves.
Morningstar's Russel Kinnel documented this
for various categories of mutual funds,
including liquid alts, using data for the 10 years
ending on Dec. 31, 2018.10 EXHIBIT 3 shows
the results.
The widely held belief was confirmed: Mutual
fund investors underperformed the funds
themselves. For liquid alts, the underperformance
was 1.44 percentage points per year, a
significant margin (13.5 percentage points) when
compounded over the decade. In equity, fixed
income, and allocation funds, they did better-
although not well. Investors and their
advisors were mostly unsuccessful at timing
fund flows.
If investors are found behaviorally to be bad
at something, they should not do it. Discretionary
timing of alts fund purchases and sales
is one of those things. They should, instead,
rebalance to a fixed allocation-which
forces a buy-low, sell-high discipline-or else
not hold the asset.
In 2022, however, cash inflows to liquid alts
were roughly equal to market losses in
that sector: inflows $27.1 billion, market
8 Daly, L. 2022. " Alternative Investments of the Ultra-Wealthy in 2022. " The Motley Fool, Sept. 26.
9 Charney, J. 2015. " Potholes and Opportunities in Alternative Investments. " Morningstar.com. July 13.
10 Kinnel, R. 2019. " Mind the Gap 2019. " Morningstar.com. Aug. 15.
44
Morningstar Q2 2023

https://www.morningstar.com/articles/942396/mind-the-gap-2019 https://www.morningstar.com/articles/691385/potholes-and-opportunities-in-alternative-investments https://www.morningstar.com/articles/691385/potholes-and-opportunities-in-alternative-investments http://www.Morningstar.com http://www.Morningstar.com

Morningstar - Q2 2023

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