The means by which investors access alternatives continues to evolve. Although limited partnerships have existed for decades and liquid alt mutual funds have become a popular access point in recent years, the closed-end fund (“CEF”) structure is gaining visibility and traction within the alternatives industry, and arguably represents the next phase in alternative investing.1,2,3
Over the past five years there has been a marked proliferation of liquid alts, yet these mutual funds not only present numerous structural challenges, they are limited to a narrow universe of alternative options. The risks inherent in liquid alternatives stem from the incongruent nature of a liquid structure and potentially illiquid underlying holdings. Under normal market conditions, redemptions are easily met. In a crisis, however, the underlying assets may be difficult to sell at a reasonable price, causing a liquid alt to become highly illiquid. XA Investments LLC believes there is no substitute for true alternative investments in fulfilling advisors’ and clients’ return, volatility, income and diversification objectives. When managers alter their investment process to fit a product structure, an alternative strategy becomes compromised and less likely to produce the same results for an individual mutual fund investor as it does an institution.
Limited partnerships have also been a standard means by which advisors access alternatives, but there are a number of “inconveniences” associated with these structures such as suitability and eligibility requirements, high investment minimums, K-1s, performance fees and a limited number of investors.4 The combination of few investors and high minimums results in concentration risk, and potential performance fees may spur investor discontent.
In contrast, a CEF’s distinctively flexible nature makes the structure well-suited for many institutional alternatives. A CEF improves accessibility for investors but does so with attractive features such as low investment minimums, no performance fees and the ease of 1099 tax forms. In addition, CEFs can be designed to offer purity of strategy and provide individuals the same investment opportunity as their institutional counterparts.
Investors should carefully weigh the diversification benefits, expected returns and volatility of liquid alts relative to alternatives offered in a limited partnership or CEF structure. During a liquidity crisis, alternative investments may become less liquid or illiquid and the prices of alternative assets may experience wide fluctuations.
The information in this article is provided as a summary of complicated topics and does not constitute legal, tax, investment or other professional advice on any subject matter. Further, the information is not all-inclusive and should not be relied upon as such. CEFs frequently trade at a discount to the fund’s net asset value. An investment in CEFs involves risks, including loss of principal. Performance data quoted represents past performance. Past performance does not guarantee future results. Current performance may be lower or higher than the performance data quoted. Diversification does not eliminate the risk of experiencing investment losses. You should not use this article as a substitute for your own judgment, and you should consult professional advisors before making any investment decisions. This information does not constitute a solicitation of an offer to sell and buy any specific security offering. Such an offering is made by the applicable prospectus only. A prospectus should be read carefully by an investor before investing. Investors are advised to consider investment objectives, risks, charges and expenses carefully before investing. Financial advisors should determine if the risks associated with an investment are consistent with their client’s investment objectives.
1The term “liquid” alts refers to a mutual fund that purports to offer alternative investment strategies, which based on the SEC requirements of a mutual fund must be highly liquid (generally 85% of a mutual fund’s portfolio must be liquid, meaning its securities can be sold within 7 days without significantly impacting their value).
2Not all institutional alternative strategies will fit in a CEF structure. While CEFs are allowed to hold less liquid assets, the Investment Company Act of 1940 (’40 Act) imposes certain limitations on a CEF’s portfolio, including trading restrictions and leverage limitations.
3DST Systems, Whitepaper. “Leveraging Alternative Portfolio Structures in a Dynamic Investment Market.” June 2017.
4Shares of limited partnerships that offer alternative investment strategies typically may be sold only to “qualified purchasers” who are defined under the ’40 Act as individuals with at least $5 million in investments and certain institutional investors. CEFs and mutual funds may be purchased by individuals without a net worth or investment portfolio minimum requirement, although advisors must consider whether an investment is suitable for a client based on the client’s financial situation, investment objectives and experience, investment time horizon, liquidity needs, risk tolerance and other factors.
5Jason T. Greene & Charles W. Hodges. “The Dilution Impact of daily fund flows on open-end mutual funds,” Journal of Financial Economics, Volume 65, Issue 1, Pages 131–158. July 2002.