The Securities Litigation Expert Blog

Liquid Alternatives - Is Democratization a Good Thing?

Posted by Jack Duval

Feb 10, 2015 7:53:00 AM


Plato, Ancient Investment Guru, from Raphael's "School of Athens"

In The Republic, Plato ranks five forms of government from best to worst.[1] They are:

  • Aristocracy (Rule by the Best)
  • Timocracy (Rule by Honor)
  • Plutocracy (Rule by the Wealthy)
  • Democracy (Rule by “the many”)
  • Tyranny (Rule by the Unjust)

You may have noticed that democracy only ranked higher than tyranny.  Hardly a ringing endorsement.

Liquid alternatives have made alternative investment strategies (or at least their likeness) available to the broad investing public.  Is this the last stop before alternative investment tyranny?  Maybe.

In the 50s and 60s, alternative investments such as hedge funds and private equity funds were the province of a handful of forward thinking managers and the ultra-wealthy (the Aristocratic phase). This evolved over time with an expansion in the types of strategies and dominance of institutional investors as clients (the Timocratic phase).  Then came the availability of strategies to the “mass affluent” or those with at least $1 million in investible assets (the Plutocratic phase). And now we are in the Democratic phase.


Jessica Lynn Rabe and Robert J. Martorana have written a book for the Democratic phase called, aptly, Alts Democratized:  A practical Guide to Alternative Mutual Funds and ETFs for Financial Advisors, published as part of the Wiley Finance Series.[2]

The book is modular, so a finance professional, attorney, or anyone else interested in a particular style of liquid alternatives can read a chapter and get up to speed.  As the title would suggest, it is aimed at financial advisors looking to integrate liquid alternatives into their asset allocation recommendations. To this end, the authors suggest their Micro-Endowment Model (“MEM”) which is a retail version of the so called “endowment model” popularized by David F. Swenson in his classic book, Pioneering Portfolio Management.[3]

Micro-Endowment Model

The MEM utilizes a core/satellite approach, using low-cost indexing for core beta strategies and alternatives to complement them in each of five asset classes.  I have listed their asset classes and the ranges of liquid alternative allocations below:[4]

  • Equity (10-30)
  • Fixed Income (10-20)
  • Real Assets (0)
  • Alternatives (5-50)
  • Cash (0)

Twenty-five to 100 percent in alternative strategies is too much, and goes from a significant level to an extreme. While the apparent (but not guaranteed) liquidity of liquid alternatives gives them more room in a portfolio, they have not proven themselves to warrant such high allocations. In bull markets they have lagged significantly and in bear markets they have performed poorly, although somewhat better on a relative basis.

Absolute Return Funds

A good example of the poor performance of liquid alternatives exists in the so-called absolute return funds, which are supposed to deliver positive performance in any environment. In the data the authors cite, through the five years ending in 2013, absolute return funds have returned 3.3 percent annually, which compares abysmally to the 17.9 percent return for the S&P 500 over the same time.[5] 

The objection on everyone’s lips is that these funds aren’t designed to outperform in bull markets.  Fair enough.  In the 10 years ending in 2013, absolute return funds averaged an annualized 1.1 percent return and suffered a maximum drawdown of -33.6 percent. The average Sharp ratio over that time was 0.1 and the average Sortino ratio was 0.07. 

This encompasses a five-year bull market from 2003 to 2008, a sharp bear market for five quarters, and a five-year bull market thereafter.  These are calamitous numbers.  As a comparison, the S&P 500 averaged a 7.4 percent annual return over the same time period with a 50.9 percent maximum drawdown.

While there are certainly individual funds that have done much better than the index numbers above,[6] as an asset class, absolute return funds cannot justify their existence. Investors simply aren’t better off being in them under all but the perfectly timed investment right before a bear market, and even then, the drawdowns are frequently similar to those of traditional investments in the same asset classes.

I don’t want to be perceived as picking on liquid alternatives, their illiquid brethren have the same problems. Warren Buffet has a now famous bet going with Protégé Partners where he wagered $1 million that an investment in the Vanguard S&P 500 Admiral index fund would beat five hedge funds picked by Protégé.  If it was a fight, it would have been called off by now.  The S&P 500 fund is up 63.5 percent versus 19.6 percent in the hedge funds.[7] 

In fairness to the authors, they are frank about their subject and in regards to absolute return funds, write “… most of these products have failed to consistently deliver the positive returns and downside protection implied by their mandates”.[8]


The authors have also included a chapter on suitability and fees.  In this chapter they have Q&As with two industry participants, Kathy Nalywajko, CTFA, an investment advisor and Principal of Legg Mason Investment Counsel and Todd Hiller, the director of Market Research at Oppenheimer Funds. 

I applaud this, as suitability doesn’t make it into many investment product books.  However, I wish the authors had focused more on how suitability really works on the ground with financial advisors and their clients.  For instance, how should advisors explain these complex products and strategies to their clients, most of whom have very little financial acumen?  What kinds of allocations are they making to alternatives and what are the different criteria they use to come up with those allocations?

Bottom line, I recommend the book for beginners and professionals alike who need a handy reference about liquid alternatives. The book is easy to use and presents good data on each style of liquid alternatives. 

The more people know about these investments, the less likely we are to reach the Tyranny phase.


For more information about liquid alternatives expert Jack Duval, click here.

To see our resources page on liquid alternatives, see this.



[1] Plato, The Republic, see Book VIII generally, 543A-569C.  I suggest Joe Sachs' translation, P.240-268.

[2] Jessica Lynn Rabe and Robert J. Martorana, Alts Democratized: A Practical Guide to Alternative Mutual Funds and ETFs for Financial Advisors; (John Wiley & Sons, Inc. Hoboken, New Jersey) 2015.

[3] David F. Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment; (The Free Press, New York, NY); 2000.

[4] See supra note 2, at 189.

[5] Id. at 23.

[6] See, for instance, the GMO Benchmark-Free Allocation Fund, which has a 10-year annualized return of 9.4 percent, a Sharpe ratio of 0.98 and a Sortino ratio of 0.91; at 27-8.

[7] Buffett’s index fund outgains hedge funds in 10-year bet; CNBC; Available at; Accessed February 6, 2015.

[8] See supra note 2 at 33.



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Topics: securities litigation, Securities Expert, Liquid Alternatives

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