Liquid Alternatives: Getting the Mix Right

Liquid alternatives offer broader access to unconventional strategies, but may not provide the exact outcome investors expect.
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In the last few years, touch-screen soda fountains have become increasingly common in fast-food restaurants, and these machines offer an impressive array of choices to thirsty customers. Still, while it's possible to serve up diet cherry vanilla sparkling water or caffeine-free raspberry root beer, the flavor experience might not be exactly what you'd expect. In the same way, liquid alternatives, which attempt to expand, eliminate, or rearrange traditional types of investment risk, may not provide investors with exactly the outcomes they expect. Here are some key questions to ask before ordering up a liquid alternative exchange-traded fund (ETF) for your portfolio.

What are liquid alternatives?

The criteria used to define liquid alternatives is still extremely fluid and subject to a large dose of interpretation. Morningstar defines these products as mutual funds or ETFs that use a mix of investment strategies, securities, or techniques to provide returns that differ from conventional, long-only exposure to more familiar asset classes, such as equities or fixed income.1 Many liquid alternative funds attempt to replicate hedge fund strategies, but there are also liquid alternative ETFs pursuing strategies for which there is no hedge fund equivalent. Nevertheless, we tend to think of liquid alternatives as investment products that create a retail vehicle for the trading strategies commonly associated with hedge funds.

Because they target retail investors, liquid alternatives are typically based on the same legal structures that underpin traditional mutual funds and ETFs, rather than aligning with the private fund rules that normally apply to hedge funds. As a result, most liquid alternative ETFs are registered under the Investment Company Act of 1940, but there are also liquid alternative ETFs based on partnership or grantor trust structures.2 This allows liquid alternative ETFs to attract investors of all sizes, not just those with "accredited" or "qualified" status, as long as they meet the same regulatory standards as other public funds.

What are the advantages of liquid alternatives?

In addition to offering broader access to unconventional strategies, here are some other advantages of liquid alternatives compared to hedge funds.

  • Liquidity: Unlike hedge funds, ETF issuers may not impose gated redemptions or require investors to commit to lock-up periods. Instead, liquid alternative ETFs can be purchased and sold on exchanges during normal trading hours. Although, as with any ETF, investors should watch for wide bid-ask spreads and volatile premiums/discounts in less actively traded products and products with less liquid holdings.
  • Lower minimums: The minimum investment for an ETF is significantly lower than it is for a hedge fund. A single ETF share can be purchased for as little as a few dollars, while a hedge fund may have an investment minimum as high as $1 million.
  • Transparency: Most ETFs are required to publish their holdings daily, which may help investors better understand what's actually inside a fund's portfolio. Hedge funds, on the other hand, have no such requirement.
  • Lower fees: Liquid alternative ETFs typically have much lower fees than hedge funds. This is due in large part to the fact that performance fees are not allowed in traditional fund structures.
  • Regulatory oversight: By using the same legal structures developed for traditional public funds, liquid alternatives are subject to more regulations and oversight. These include restrictions on the use of leverage and short selling, which may dampen volatility.

What are the disadvantages of liquid alternatives?

Here are a few things to consider.

  • Complexity: Investors who are considering liquid alternative ETFs should be prepared to spend a considerable amount of time researching their options. Many liquid alternative strategies are complicated and can leave even professional investors scratching their heads! Be prepared to ask lots of questions, either to your financial advisor or to the ETF issuer directly. And keep in mind that past performance is not a shortcut and doesn't imply future success.
  • Closure risk: Although any ETF may close (due to poor performance or lack of investor interest), Morningstar reports that the average age of alternative funds is lower, and the number of funds closed is higher.3 Investors who own shares of an ETF that has announced its closure will need to decide whether to sell before the fund delists or wait for the fund's final liquidating distribution. Additionally, these investors must recognize a gain or loss at a time they might not expect and may need to spend more time researching a replacement fund.
  • Higher fees: While liquid alternatives are usually less expensive than hedge funds, they tend to be more expensive than other types of mutual funds and ETFs. Although higher fees may be justified (managing more complicated strategies often requires larger teams and more technological resources), investors should consider whether a fund's potentially higher returns might simply be eaten-up by its higher fees. According to Morningstar, in 2021 the asset-weighted average fee was 1.10% for actively managed alternative funds and 0.65% for alternative funds tracking indexes. This compares to 0.60% for all active funds and just 0.12% for all funds tracking indexes.4
  • Investment Limitations: Liquid alternative ETFs registered under the Investment Company Act of 1940 face limitations on holding illiquid, short, and leveraged positions. As hedge funds do not face such limitations, there may be alternative investment strategies that liquid alternative ETFs cannot effectively implement.
  • Investor gap: Finally, investors should consider whether they have the patience and temperament to endure a significant stretch of underperformance combined with bouts of short-term volatility. Morningstar reports that most investors haven't had the stomach for liquid alts as shown by the gap between time and dollar-weighted returns, which incorporate cash flows into and out of the fund to measure how the average investor performed over time.5

How can I find liquid alternative ETFs at Schwab? And where should I begin my research?

To start, use the ETF screener to identify alternative ETFs by Morningstar category. After analyzing the fund's research page on Schwab.com, locate the issuer's own website to review the fund's fact sheet, prospectus, and any other materials the issuer may provide to help explain the investment strategy. Comparing at least a few funds in the same category may help you understand the strengths and weaknesses of each one.

Use the ETF screener to identify alternative ETFs by Morningstar category.

Liquid alternative fund categories

  • Alternative
  • Alternative
    Digital Assets
  • Digital asset portfolios provide exposure to blockchain, stable coins, currency assets, smart contracts platforms, exchange assets, privacy assets, yield farming, and nonfungible tokens (NFTs), among other assets. Portfolios may gain access to digital assets through physical or derivative exposures and incorporate both long-only investments and other hedging techniques. 
  • Alternative
    Equity Market-Neutral
  • Equity market-neutral strategies attempt to profit from long and short stock selection decisions while minimizing "systematic" risk (i.e., risk inherent to the overall market, not just a specific industry or stock). They try to achieve this by matching long positions within each area against offsetting short positions. 
  • Alternative
    Event-Driven
  • Event-driven strategies attempt to profit when security prices change in response to events such as bankruptcies, mergers and acquisitions, emergence from bankruptcy, shifts in corporate strategy, and other atypical events. Activist shareholder and distressed investment strategies also fall into this category. 
  • Alternative
    Macro Trading
  • Macro trading strategies look for investment opportunities by studying such factors as the global economy, government policies, interest rates, inflation, and market trends. These funds are not restricted by asset class and may invest across such varied assets as global equities, bonds, currencies and commodities. 
  • Alternative
    Multi-Strategy
  • Multi-strategy portfolios offer investors exposure to two or more alternative investment strategies, as defined by Morningstar's alternative category classifications. Multi-strategy funds typically aim to have low to modest sensitivity to traditional market indexes.
  • Alternative
    Options Trading
  • Options trading strategies use a variety of options trades, including put writing, options spreads, options-based hedged equity, and collar strategies, among others. 
  • Alternative
    Systematic Trend
  • Systematic trend strategies primarily implement trend-following, price-momentum strategies by trading long and short liquid global futures, options, swaps, and foreign exchange contracts. 
  • Nontraditional Equity
  • Nontraditional Equity
    Derivative Income
  • Derivative income strategies primarily use an options overlay to generate income while maintaining significant exposure to equity market risk. Income is typically generated through covered call writing strategies, for example, while traditional equity risk factors dictate a substantial portion of the return. 
  • Nontraditional Equity
    Long-Short Equity 
  • Long-short equity portfolios hold sizeable stakes in both long and short positions in equities, exchange-traded funds, and related derivatives. 
  • Allocation 
  • Allocation 
    Global Allocation
  • Global-allocation portfolios seek to provide both capital appreciation and income by investing in three major areas: stocks, bonds, and cash. While these portfolios do explore the whole world, most of them focus on the U.S., Canada, Japan, and the larger markets in Europe. 
  • Allocation 
    Tactical Allocation
  • Tactical allocation portfolios seek to provide capital appreciation and income by actively shifting allocations across investments. These portfolios have material shifts across equity regions, and bond sectors on a frequent basis. 
  • Taxable Bond 
  • Taxable Bond 
    Nontraditional Bond
  • Inclusion in nontraditional bond is informed by a balance of factors determined by Morningstar analysts. Funds in this group typically have the flexibility to manage duration exposure over a wide range of years and to take it to zero or a negative value.  
  • Miscellaneous
  • Miscellaneous
    Trading - Miscellaneous
  • These funds seek to generate returns equal to a fixed multiple (positive or negative) of short-term returns of an index that is not equity, fixed-income, or commodity linked. Many of these funds seek to generate a multiple of the daily or weekly return of the reference index. Trading funds are not considered suitable for a long-term investor and are designed to be used by active traders. 

How will I know if liquid alternatives are a good choice for me?

While this isn't an easy question to answer, investors who are comfortable with short-term volatility and have a high tolerance for risk may find liquid alternative ETFs to be a good choice—if they are able to devote the considerable time and energy necessary to fully understand these products. Conservative investors who aren't comfortable with complex or high-risk products should probably steer clear.

Also, investors should think carefully about their time horizon before investing in liquid alts. Because these products are prone to both short-term volatility and longer-term underperformance, investors will want to carefully consider how these products may fit with their investing goals. And yet, it's also important for investors to be flexible! Liquid alternative ETFs are more likely than other types of ETFs to close, which could result in an unexpected tax situation and follow-up research to choose a replacement fund.

Finally, if you think liquid alternative ETFs might be right for you and you spend some time digging into liquid alts, but find yourself with more questions than answers … you're not alone! These complicated strategies are difficult to understand and should be expected to generate unpredictable and potentially volatile returns. To avoid having liquid alternative ETFs leave a sour taste in your mouth, do as much research as possible. Ask lots of questions, ask some follow-up questions, and then ask even more questions! At the end of the day, these products are only suitable for investors who are fully educated and braced for unexpected outcomes (sort of like a sugar-free lime cola).

1 Alitovski, E., et al., "2021 Global Liquid Alternatives Landscape," Morningstar, July 2021, page 2.

2 Liquid alternative exchange-traded notes (ETNs) are technically uncollateralized debt.

3 Alitovski, E., et al., "2021 Global Liquid Alternatives Landscape," Morningstar, July 2021, page 7.

4 Armour, B., et al., "2021 U.S. Fund Fee Study," July 2022, page 3.

5 Alitovski, E., et al., "2021 Global Liquid Alternatives Landscape," Morningstar, July 2021, page 12.