Fidelity dumps two liquid alts managers after they fail to deliver the vaunted 'hedge effect' in stormy markets

This time it was a retail effort by the very institutional Blackstone Group LP that fell victim to Fidelity Investments’ double-bladed sword.

Fidelity has, once again, unceremoniously removed client funds from a liquid alternative mutual fund in what can’t be a good sign for a category of investments only recently given auditions by branded retail firms. See: Now come the robo-alts firms — a full flock of 'em as unwavering as the robo-advisors.

In the first three weeks in March, the hulking Boston-based investments firm pulled $585 million of client funds from the Blackstone Alternative Multi-Manager Fund (BXMMX), or about half of that fund’s total assets. Fidelity first invested in the Blackstone fund in 2013 and it may have seemed like a safe brand. See: Buy alternative investments and get over Madoff, especially as interest rates threaten to rise: columnist Fidelity can’t be accused of “me too” syndrome in terms of jumping into retail per se. It had a hedge fund of funds dating back to the early 1990s — as much for senior partners of the firm to invest in as anything.

Blackstone Group, which manages more than $300 billion, will no doubt survive, but this fund is near dead. Blackstone Alternative Multi-Manager Fund will be liquidated by May 31, according to a filing it made yesterday with the U.S. Securities and Exchange Commission. Assets in the fund had collapsed to $629.8 million from $1.2 billion at the end of February leaving Fidelity as essentially the sole owner of the shares, according to a Bloomberg article.

Fidelity had already delivered a similar blow to the Arden Alternative Strategies Fund (ARDNX): In February it pulled hundreds of millions in assets forcing it to liquidate. Fidelity first put assets with Arden in 2012. Aberdeen Asset Management Inc. purchased Arden Asset Management LLC on Dec. 31, 2015. At the time it managed about $10 billion.

Whether one views Fidelity’s moves in the light of a manager-of-managers firing a manager or as the firm’s growing distaste for the whole field, the company offered was a pallid endorsement for the category.

Liquid situation

“We will not be removing all of the alternatives exposure from our managed account portfolios,” says Nicole Goodnow, a spokeswoman for Fidelity. “Fidelity currently maintains an alternatives exposure within its managed account portfolios and we do not expect this to change.” See: How the alternative investments category got bastardized and why that’s a shame.

Indeed, Fidelity has continued to pour its efforts into building up its alts platform for RIA custody clients that features Goldman Sachs. See: Fidelity teams with Goldman Sachs as part of big push into alternative investments on behalf of RIAs.

Will Fidelity substitute other liquid alts for the ones it liquidated? RIABiz posed that question to Goodnow and got this response:

“As a general practice, we do not discuss our future trading intentions.”

High hurdle

The fate of Arden and Blackstone at the hands of unsentimental Fidelity investment managers underscores broader concerns about the whole liquid alternative category of products, says Josh Charlson, director of manager research for alternative strategies at Morningstar. in Chicago.

“Although the high costs have come down, returns have not surpassed their hurdle rate.”

In other words, liquid alternative fund managers in general are not carrying their own weight. That “hurdle” computation is based on what liquid alts charge relative to the returns they generate. It also involves compensating for the fact that the short positions of liquid alt funds handicap them in a bull market against comparable funds that invest only in long positions.

Arden showed a 0.15% yield over the life of the fund (as of March 29); Blackstone returned 2.71%, a return that has continued to worsen. Right now Blackstone’s BXMMX trades at about $9.54, whereas in 2013 it mostly traded from $10 to $10.50.

Both these funds had high expense ratios — more than double of other funds available to Fidelity customers. The gross expense ratio for BXMMX is 3.28% and the net expense ratio is 2.75%, according to Fidelity’s website. The gross expense ratio for Arden’s ARDNX is 3.85% and its net expense ratio is 2.04%.

Short leash

And although Fidelity calling to account these alternative managers so early in their relationship and Fidelity’s willingness to toss them out wholesale may speak to a broader vote of no confidence, it may say more about how Fidelity has defined their usefulness.

“Since the 2008 financial crisis, asset class performance has often grown more correlated and short-term interest rates have remained low,” says Goodnow. “We believe an allocation to alternative investments may help improve the overall risk and return of the portfolio through a full market cycle given the potential value that alternative investment managers offer through their ability to identify and trade on persistent market anomalies.” See: How the Winklevoss twins disrupted a big NYC hedgie event and distracted from the poor job most hedge funds are doing for clients.

Though none of the we sources contacted — on or off record, in or out of Fidelity — offered specifics about why Fidelity disgorged these assets, the same sources suggest that Blackstone and Arden were likely on short leashes because of their expense ratios, the relative novelty of their approach and the high expectations generated by the firm.

Liquid alts’ pitch to investors is nothing less than being able to possess and consume their cake, i.e. getting the liquidity of mutual funds with the benefits of holding illiquid hedge funds. Put more simply, hedge funds are sold as an elegant way to receive steady returns in up and down markets.

More recently, Wall Street has refined its alts pitch, touting them as a way to avoid the bond markets altogether where interest rates have made tatters of investors’ returns. See: Feeling its oats in post-Genworth life, Altegris does a deal with KKR anchored by a big Merrill Lynch brokerage commitment.

Investors were particularly receptive to that pitch after the market meltdown of 2008, when ordinary brokers and average mutual funds took a beating with traditional long-only stock and bond portfolios. A hedge fund will usually charge more, put restrictions on redemptions and, by law, open its doors only to “sophisticated” — that is wealthy — investors who are seen to be able to absorb big losses.

Narrow reading

Fidelity, The Charles Schwab Corp. and brokers gave tacit approval to this pitch by putting hedge funds wrapped inside liquid mutual funds in reach of their investors. The funds offered daily redemptions and a chance for retail investors to get exposure to hedge fund strategies such as troubled debt, commodity speculation and shorting stocks. The idea had particular sex appeal in that it allowed customers to access hedge fund strategies that were previously reserved for ultrahigh-net-worth individuals and institutions. The liquid alternative fund’s minimum investment on average is $190,000 compared to $1.3 million for most hedge funds. See: A cottage industry of hedge funds-to-RIAs is springing up but so far the mutual fund industry looks like the big winner.

But in 2016, Fidelity’s notion of an alternatives investment is fairly narrow

“When the SAI investment team considers using alternative strategies in our portfolios, they typically look at those that have an absolute return mandate, and that seek relatively low beta and correlation with traditional asset classes,” Godnow says. “This more narrow definition of 'alternative’ means we stay away from certain popular alternative strategies such as direct investment in private equity, natural resources and infrastructure.” See: How a Chicago RIA of PWC origin jumped to $1 billion by lacing its DFA approach with alternative assets.

Fidelity played it safe by using Arden and Blackstone as small positions in the portfolios it manages. Its managed account program, Fidelity Portfolio Advisory Service, has about $100 billion in assets and alts never represented more than 2% of that total, according to the company. PAS fees can range from between 0.60% and 1.7% and the average investor pays Fidelity .85% — before paying additional fees to underlying managers.

'Overhyped’

“Alternative investing has become a sales pitch, when it used to be a well thought out differentiator for a small group of advisors who understood the reward and risk potential of liquid alts, as well as how to apply them to their clients situations in a prudent manner,” says Robert A. Isbitts, chief investment strategist of Sungarden Investment Research in Guilford, Conn. See: 10 investment ideas that STILL don’t work.

“Too much of what I see today indicates we are in the 'me too’ phase of this liquid alts cycle.”

The liquid alternative fund market had grown steadily since 2008, according to data supplied by Morningstar. in Chicago. Only about $43 billion was under management in that year but the number of new funds has increased every year since. The liquid alt fund market apparently peaked in 2014 with 114 new funds coming on line. Assets in liquid alt funds also peaked in 2014 at approximately $310 billion. See: A more liquid alternative to alternative investments catches on.

The expectations that allowed liquid alts assets to explode nearly eight-fold in less than five years looks are now lowered in retrospect.

“They may have been overhyped; expectations were high. People expect hedge fund managers to do better,” says Isbitts. “The Hedge Fund index shows that hedge fund managers, with a few exceptions, have not really posted exceptional results.”

High hurdle, lower costs

Performance — or the lack of it — may be one reason for Fidelity’s about-face. Arden showed a 0.15% yield over the life of the fund (on March 29); Blackstone returned 2.71%. Perhaps that is not what Fidelity expected from some of the best hedge fund managers.

Both these funds had high expense ratios, more than double of other funds available to Fidelity customers. “Although the high costs have come down, returns have not surpassed their hurdle rate,” says Charlson.

Schwab offers its self-managed Schwab Hedged Equity Fund (SWHEX) with a lower expense ratio of 1.84%. It has also demonstrated strong returns in the past year, up about 10%. See: Schwab wins long-awaited green light from the SEC on alternative-assets distribution.

For advisors who want less cost, the IQ Hedge Multi-Strategy Tracker ETF (QAI) tracks the performance of the IQ Multi-Strategy Index, which seeks to replicate the risk-adjusted return characteristics of collective hedge funds. It charges .97%. See: Schwab leads effort to create industrywide solution for alternative assets.

Not buying it

Liquid alt funds offered an opportunity for the hedge fund managers to access a vast pool of funds from ordinary investors who were not wealthy enough to meet the minimum standard to be considered accredited investors.

But despite the hype, ordinary investors did not bite. See: The hedge fund legal elite meet in NYC to wrestle with a terrifying new threat — RIA-like accountability.

Carlyle shut down a liquid alternative fund last year that had raised only $53 million. KKR did the same with a similar fund that raised only $33 million. See: Feeling its oats in post-Genworth life, Altegris does a deal with KKR anchored by a big Merrill Lynch brokerage commitment.

Gottex Fund Management, based in New York, Switzerland, the United Kingdom and Canada, has closed its Gottex Endowment Strategy Fund (GTEAX), which was launched in early 2014. It offered investors a mix of strategies often pursued by endowments, such as using hedge funds, private equity, special-situation investing and real estate. By early March 2016, the fund assets had declined to less than $20 million due to redemptions.

Since 2014, the number of alts funds has declined and the total amount of assets under management is down about 10%.

The traditional refrain of the alts industry is to wait for a rough market to see the power of a hedged strategy. With the broad market flat in 2015, the hedge fund managers certainly had an opportunity to shine, but continued to sputter.

It’s the kind of thing that’s hard to explain away to managers at Fidelity.