By Jerry Szilagyi, CEO of Catalyst Mutual Funds

New strategies are being offered in the mutual fund structure as more investors seek access to hedge fund strategies. Liquid alternative mutual funds offer investors the potential to access the benefits of a hedge fund strategy, such as diversification and low correlation to equity and fixed income indexes, with the daily liquidity, transparency and fee structure of a mutual fund. Given the benefits, it’s not surprising that these assets have experienced tremendous growth, both in assets and number of funds.

Historically, the growth of these assets was mired with restrictions on offering certain traditional hedge-type strategies in mutual fund format. The restrictions range from limits on leverage, liquidity, derivatives and performance fees to investments in “non-securities,” including commodities. Wall Street’s answer to these restrictions has been to develop different structures that offer some of the “restricted strategies,” while still conforming to mutual fund regulations.

Access to these strategies undoubtedly benefits investors, if implemented correctly. However, finding winning investments in the liquid alternative mutual fund space has become increasingly more difficult. As advisors and investors seek to diversify their portfolios, they are flooded with options and little information on how to best evaluate which liquid alternative mutual funds will provide the most attractive risk-adjusted returns. To navigate today’s liquid alternative mutual fund environment, investors must first understand the fund structure and then be aware of the potential risks and additional costs associated with the underlying investments, including liquidity, leverage and fees.

Understand the Fund’s Structure

Many categories of liquid alternatives – long/short equity, market neutral and tactical funds – are well established, relatively straightforward and can be more easily analyzed. In an effort to abide by regulatory restrictions, some alternative funds use more complex structures to implement their strategies. While allowing for investment in “restricted strategies,” these complex structures can be difficult to understand and evaluate. Three of the more common structures used by liquid alternative funds to invest in otherwise “restricted strategies” are controlled foreign corporation (CFC), structured notes and total return swaps.

A CFC is essentially an offshore fund that is a wholly owned and controlled subsidiary of the mutual fund. The mutual fund can invest up to 25% of its assets in the CFC. This structure is commonly used to hold commodities futures investments in managed futures or multi-alternative funds. Structured notes and total return swaps are obligations of an issuer, often a large global bank. Held by a mutual fund, the structured notes and return swaps are designed to pay out the investment return of the underlying strategy without actually holding the investments of the underlying strategy.

Understand the Underlying Investments

While CFC, structured notes and total return swaps provide an opportunity to invest in otherwise “restricted strategies,” these structures may add additional costs to the mutual fund expenses, which are not always included in the standard prospectus expense table. It is extremely important to look under the hood to fully understand what the underlying investments and costs are in these alternative fund structures. Areas of focus should include: leverage, expenses and liquidity. Research whether additional leverage is being used in the underlying fund structures – either directly or indirectly through the use of derivatives. Determine what fees are being charged by the underlying managers and/or structure providers, like management fees, performance fees and structuring fees. And, consider whether there any potential liquidity concerns with the underlying investments.

Understand Fund Effectiveness

Finally, to assess the effectiveness of the alternative strategy in providing attractive risk-adjusted returns, examine the fund’s statistical profile: alpha, beta and correlation to the relevant index or benchmark. Beyond the pure statistics, it is also important to understand a fund’s expected return profile – how the fund is expected to perform in various market conditions.  Analyzing effectiveness will help with both positioning the fund in your portfolio as well as selecting the right fund among many that seek the same alternative strategy.

The growing number of liquid alternative mutual funds and strategies is a benefit to investors and advisors. However, the space remains extremely complex. As more investors seek diversification from hedge fund-type strategies, it is important to better understand strategies being offered by mutual funds. To best benefit from liquid alternative mutual funds, investors must first understand the restrictions, various fund structures, strategies and potential additional costs. It is with this understanding that investors have the opportunity to invest smarter within the liquid alternatives space.