Morningstar - Q2 2023 - 45

losses $28.6 billion (both numbers through
Nov. 30).
Expense Ratios for Liquid-Alts Funds %
(Weighted by AUM)
The 2022 result, that investors bought instead
of sold into a falling market, was an
improvement on earlier behavior, when
investors did the opposite.
Liquid-Alternatives Fund Fees and
Expenses
Fees and other investment expenses are
key to understanding the hazards of liquid
alternatives. The " dimensions of active
management, " as described by Barton Waring
and me in a widely circulated 2003 article,
are alpha, active risk, and fees.11
For brevity,
let's just call all mutual fund expenses
paid by the investor " fees, " even though that
is not precisely accurate.12
Some things should be expensive. A predictable
stream of positive alpha is one of them.
A manager who can produce such a stream is
worth high fees, probably higher than any
existing manager charges.
But most funds should not be expensive. Index
funds set a benchmark of what managers
should charge for average performance: almost
nothing. Remind yourself that the average
return of all active managers has to be,
by mathematical certainty, the return on the
market minus fees.13
The following table shows basic statistics of the
expense ratios of the 726 share classes
of liquid-alts funds for which Morningstar
provided data.14
The spread between
the most expensive and the cheapest funds is
astounding, a nearly 16/1 ratio:
Mean
Median
Standard Deviation
Maximum
Minimum
Number of Funds
Number of Share Classes
Source: Morningstar. Data as of Dec. 31, 2022.
An expense ratio of 4.75% per year? Really?
Ignoring compounding and market profits,
that fee schedule would transfer all of
the client's money to the manager in 21 years!
The profits had better be lavish; they were
not. The performance of that fund was
not shameful, but if the expense ratio had
been at the median, 1.29%, it would have been
impressive for a portfolio with a beta
of only 0.14. (The low beta indicates that some
diversification was achieved.)
The manager consumed the lion's share of the
profits from the fund's trading strategy. Don't
recommend funds with sky-high fees! A fund will
occasionally be worth its high fees, but only
rarely, and we don't know in advance which funds
they will be.
Because most of the funds are small in terms of
AUM, it's worth inquiring whether one can
save on fees and expenses by only investing in the
biggest funds. The table below shows the
statistics for the 30 funds with over $1 billion. As in
the table above, each share class is weighted
according to its AUM:
1.46
1.29
0.76
4.75
0.30
409
726
Expense Ratios for Large Liquid-Alts Funds %
(More Than $1 Billion AUM)
Mean
Median
Standard Deviation
Maximum
Minimum
Number of Funds
Number of Share Classes
Source: Morningstar. Data as of Dec. 31, 2022.
The statistics for the funds over $1 billion are
almost identical to those for all funds.
Only the maximum expense ratio is significantly
different (because the biggest outliers are
small funds). Thus, investing only in the biggest
funds does not save the investor money.
To summarize this fee discussion, I quote Cliff Asness,
that wise and witty provider of, among other
things, liquid-alternatives funds, who has said that
no investment strategy is so good that it is still
good after subtracting an indefinitely large fee.
Should Advisors Offer Alts?
I've covered return, risk, fees, AUM, and funds
flows (this last item testing the hypothesis that
flows follow performance, so that returns
to the typical investor are lower than returns
to the fund). Let's turn to the suitability of
liquid-alts funds for the class of clients serviced
by the advisor community.
Writing in InvestmentNews, reporter Mark Schoeff
Jr. recommended that advisors include alternatives,
including liquid ones, in their quiver of arrows
for attracting and retaining high-net-worth clients.15
1.42
1.51
0.76
3.52
0.33
30
102
11 Waring, M.B. & Siegel, L.B. 2003. " Understanding Active Management. " Investment Insights, BlackRock, April.
12 Some investment expenses that are included in the expense ratio are paid by the manager to third parties and are thus not kept by the manager as revenue; and some expenses are frictional,
such as trading costs. These, too, are not revenue to the manager.
13 Sharpe, W. F. 1991. " The Arithmetic of Active Management. " Financial Analysts Journal, Vol. 47, Issue 1 (January/February).
14 The Morningstar liquid-alts database includes a large number of " options trading " funds that have a share class for each option expiry date. Most of these are buffer funds, which deliver the
return on an index or benchmark within a prespecified range over a prespecified period of time and provide (full or limited) downside protection and reduce (or eliminate) upside capture if
the index return is outside that range. Because options trading funds follow a relatively simple strategy, they generally (but not always) have lower expense ratios than the other six categories
of funds. The large number of share classes for these funds skews the average expense ratio down. This may be one of the reasons that the weighted average expense ratio that I calculated
(1.46%) is lower than the average cited by Rekenthaler (1.66%). Another reason may be that my calculation goes through Dec. 31, 2022, while Rekenthaler's only goes through May 31, 2021.
15 Schoeff, M. 2022. " Advisers Should Look to Alts to Attract High-Net-Worth Clients, " InvestmentNews. Dec. 13.
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