# Understanding Liquid Alternatives: Strategies, Risks, and Benefits

> **Definition**
>
> Liquid alternatives are mutual funds that use strategies like those of hedge funds but offer daily liquidity.

## What Are Liquid Alternatives?

Liquid alternatives (or liquid alts) are [alternative investment](https://www.investopedia.com/terms/a/alternative_investment.asp) vehicles that aim to be more accessible to retail investors. They're mutual funds or exchange-traded funds (ETFs) that aim to provide retail investors with [diversification](https://www.investopedia.com/terms/d/diversification.asp) and [downside protection](https://www.investopedia.com/terms/d/downside-protection.asp) through hedge fund-like strategies with daily [liquidity](https://www.investopedia.com/terms/l/liquidity.asp).

The benefits of accessibility to liquid alts for [retail investors](https://www.investopedia.com/terms/r/retailinvestor.asp) include lower minimum investments than the typical [hedge fund](https://www.investopedia.com/terms/h/hedgefund.asp) and not having to pass net-worth or income requirements to invest. The potential risks include high fees and liquidity concerns during market downturns.

Key categories of liquid alternative strategies include long-short equity, managed futures, market neutral, multialternatives, and nontraditional bonds.

Given the risks and market conditions associated with liquid alts, it's important to understand these funds before investing.

### Key Takeaways

*   Liquid alternatives, or liquid alts, provide retail investors access to hedge fund strategies with daily liquidity and lower investment minimums.
*   These funds aim to offer diversification and downside protection through alternative investment strategies.
*   Critics argue that the fees for liquid alternatives are high and the liquidity might not withstand volatile market conditions.
*   Liquid alt strategies include long-short equity, nontraditional bonds, market neutral, managed futures, and multialternatives.
*   The popularity of liquid alts has led to an increase in funds, but also to a wave of closures and consolidations in the market.

## How Liquid Alternatives Function in the Market

Liquid alts aim to counteract the drawbacks of alternative investments by providing investors with exposure to alternative investments through products that can be redeemed daily, just like a mutual fund.

Alternative investments refer to assets other than long-only stocks or bonds. Examples include [fine art](https://www.investopedia.com/articles/pf/08/fine-art.asp), private equity, derivatives, commodities, real estate, [distressed debt](https://www.investopedia.com/terms/d/distressedsecurities.asp), and hedge funds. A drawback of any of these investments, however, is their lack of liquidity. Under normal market conditions, a $5,000 position in Alphabet Inc. is easy enough to offload in milliseconds without affecting the price. Even if the private equity market is in rude health, however, it will take considerably more time and effort to sell an alternative investment, and there may be lock-up periods. It can also be more difficult to take a small position in alternative investments.

> **Fast Fact**
>
> The full name of liquid alternatives (or liquid alts) is liquid alternative investments.

## Challenges and Criticisms of Liquid Alternatives

Liquid alternative funds have grown since the 2007 financial crisis because investors want to protect against risks using hedge fund strategies. In a July 2015 survey, Barron's and Morningstar found that 63% of advisors planned to allocate more than 11% of their portfolios to liquid alts within the next five years. Since then, however, the liquid alts market has seen an influx of fund closures and consolidations, leading to a period of slowed growth for the market, which reached a size of $192 billion, as measured by assets, at the end of 2015. Asset growth in the market has remained inconsistent, and per Strategic Insight, liquid alt assets rebounded to $184 billion at the end of the third quarter in 2017, from $179 billion at the end of 2015.

Critics note that liquid alts often have higher fees than other [actively managed](https://www.investopedia.com/terms/a/activemanagement.asp) mutual funds. Also, stuffing otherwise illiquid assets into liquid packaging has the potential to backfire. Hedge funds generally require investors to agree to withdraw funds only every quarter or year. The ability to trade in and out of liquid alts has contributed to their popularity, but if a downturn precipitates a run on the funds, providers may be forced to sell assets at sharply discounted prices, and investors may suffer as a result.

## Key Liquid Alternative Strategies and Their Categories

Morningstar has identified 12 categories described as liquid alternative strategies. The largest, accounting for over 80% of the funds at the time, were the following:

*   [**Long-short equity**](https://www.investopedia.com/terms/l/long-shortequity.asp): Funds that concentrate on equity securities and derivatives and combine long positions with short bets achieved through ETFs, options, or plain-old short stock positions. The balance of short to long positions will depend on the fund's macro outlook.
*   **Nontraditional bond**: These funds take unconventional approaches to bond investing, often trying to achieve returns that are uncorrelated with the bond market. "Unconstrained" funds invest with a high degree of flexibility, taking positions in high-yield foreign debt, for example.
*   [**Market neutral**](https://www.investopedia.com/terms/m/marketneutral.asp): Funds that seek to minimize systematic risks born of overexposure to specific sectors, countries, currencies, etc. They aim to match short positions and long positions within these areas and achieve low [beta](https://www.investopedia.com/terms/b/beta.asp).
*   [**Managed futures**](https://www.investopedia.com/terms/m/managed-futures.asp): These funds invest primarily through derivatives, including listed and over-the-counter (OTC) futures, options, swaps, and foreign exchange contracts. Most use momentum approaches, while others follow mean-reversion or other strategies.
*   **Multialternative**: These funds combine different alternative strategies, such as those listed above. They may have fixed allocations to set strategies or vary their approaches depending on market developments.

Other categories include bear market, multicurrency, volatility, and trading-leveraged commodities (the last includes just one fund). Citi has listed three different types of mutual fund structures that classify as liquid alternatives: single-manager funds, multialternatives, and commodities (or managed futures) funds. Meanwhile, Goldman Sachs has devised a different set of categories that more closely parallel strategies commonly employed by hedge funds. Goldman has divided its universe of liquid alt funds into equity long/short, tactical trading/macro, multistrategy, [event-driven](https://www.investopedia.com/terms/e/eventdriven.asp), and [relative value](https://www.investopedia.com/terms/r/relativevalue-funds.asp) approaches.

## The Bottom Line

Liquid alternatives (or liquid alts) are mutual funds or ETFs that provide retail investors access to alternative investment strategies with the advantage of daily liquidity. Their accessibility comes from lower investment minimums than those of traditional hedge funds, plus no net-worth or income requirements to invest.

The goal of liquid alts is to offer diversification and downside protection by employing strategies similar to those used by hedge funds. The selling point is that they are liquid, meaning that they can be bought and sold daily, unlike traditional alternatives, which offer monthly or quarterly liquidity.

Benefits of liquid alternatives include liquidity and accessibility. Criticisms include concerns over high fees, the potential mismatch of illiquid assets in liquid packaging, and liquid alts' performance during market volatility.

Investors seeking hedge fund strategies to protect against risk have contributed to the growth of liquid alts since the 2007 financial crisis. But the liquid alts market has seen fund closures and consolidations since, and asset growth in the market has been inconsistent.

While liquid alternatives can be a valuable addition to a diversified portfolio, investors should be aware of these funds' unique (and sometimes opaque) risks and high fees.

> **Article Sources**
>
> 1.  Morningstar, via Internet Archive Wayback Machine. "[Potholes and Opportunities in Alternative Investments](https://web.archive.org/web/20230308101731/https://www.morningstar.com/articles/691385/potholes-and-opportunities-in-alternative-investments)."