Liquid Alternatives: Strategies, Risks, and Benefits

What Are Liquid Alternatives?

Liquid alternatives (or liquid alts) are alternative investment vehicles that aim to be more accessible to retail investors. They're typically structured as mutual funds or exchange-traded funds (ETFs) that aim to provide retail investors with diversification and downside protection through hedge fund-like strategies with daily liquidity.

Compared with traditional hedge funds, liquid alternatives generally have lower investment minimums and do not require investors to meet net-worth or income thresholds. However, these advantages come with trade-offs, including higher fees than many traditional funds, liquidity concerns during market downturns, and greater reliance on complex or derivative-based strategies.

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

How Liquid Alternatives Function in the Market

Liquid alternatives are designed to address one of the primary drawbacks of traditional alternative investments: illiquidity. Unlike hedge funds or private investments, which may impose lockups or limited redemption windows, liquid alts typically allow daily redemptions, similar to traditional mutual funds.

However, this liquidity is built into the fund’s structure and is not guaranteed in all situations. When markets are under stress, funds that hold less liquid assets might have to sell them at low prices to meet redemption requests, which can make losses worse.

Challenges and Criticisms of Liquid Alternatives

Liquid alternative funds have expanded since the 2007 to 2009 financial crisis, as investors looked for more ways to diversify and protect their portfolios beyond just stocks and bonds.

Over the past decade, the liquid alternatives market has changed a lot. There was a rush of new funds at first, but then many closed, merged, or combined strategies as investors reconsidered performance, fees, and how these funds fit in their portfolios. Instead of widespread use, interest has shifted to more specific strategies.

Critics still note that fees are often higher than those of ETFs and actively managed mutual funds. They also worry about putting complex or less liquid strategies into funds that offer daily liquidity. Some funds have held up well, but others have had trouble justifying their costs or providing steady diversification through different market cycles.

Key Liquid Alternative Strategies and Their Categories

Research firms such as Morningstar classify liquid alternative funds into multiple strategy categories. Common approaches include:

• Long-short equity: Funds combining long positions with short exposure using stocks, ETFs, or derivatives.
• Nontraditional bond: The funds use flexible bond strategies that may include high-yield, foreign, or derivative exposures to achieve returns not typical of bond investing.
• Market neutral: Funds that aim to reduce broad market risk by balancing long and short positions across sectors, countries, or currencies. The goal is to limit sensitivity to overall market moves, so returns are driven more by security selection than by market movements.
• Managed futures: These funds use futures, options, swaps, and currency contracts, often employing trend-following strategies.
• Multialternative: Funds that combine multiple alternative strategies within a single fund.

Although classification systems vary among research firms and asset managers, investors increasingly evaluate liquid alternatives based on how they generate returns, how they correlate with other assets, and the role they serve in a portfolio, rather than relying solely on category labels.

The Bottom Line

Liquid alternatives are mutual funds or ETFs that let retail investors use hedge fund-style strategies. They offer daily liquidity and lower investment minimums compared to traditional hedge funds.

These investments are attractive because they are accessible and flexible, but there are important factors to consider. High fees, complex strategies, and possible liquidity risks, especially during market stress, need careful review.

As the liquid alternatives market has grown, investors have become more selective. Instead of using them as a single solution, people now see liquid alternatives as tools for specific purposes, like diversification or risk management, within a balanced portfolio.