Hedge Funds vs. Liquid Alternatives

Investment Strategies

Hedge Funds vs. Liquid Alternatives:Bleeding Green

Crystal Capi ta l Partners, LLC Q3-2012

In the case of a serious medical emergency, what surgeon would you choose? Would you look for the least expensive or the most accomplished? It’s likely that we all agree we would opt for the most accomplished. Accordingly, shouldn’t we treat our investments with the same level of care?

Investment Strategies | Liquid Alternatives

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IntroductionSince the aftermath of the financial crisis, mar-ket participants and financial advisors have placed a renewed emphasis on downside pro-tection and the inclusion of non-correlated as-sets within a client’s strategic asset allocation mix.

This has naturally resulted in an overwhelming interest in Alternative Investments; particularly hedge funds and their more readily tradable counterparts known as liquid alternatives.

However, it is important to recognize the con-siderable tradeoff investors encounter between

these two products. While liquid alternatives are certainly a more liquid solution, there are signifi-cant costs involved in utilizing them as a substi-tute for an actual direct hedge fund allocation.

Specifically, the ability to access daily liquidity comes at the expense of capturing attractive absolute and risk-adjusted returns, which have been historically reserved for the most institu-tional-quality hedge funds.

This paper summarizes the differences between institutional-quality hedge funds and liquid alter-native funds.

Page | 1 Please see Important Disclosures at the end of this document

Crystal’s hedge fund portfolio services break down the common barriers associated with hedge fund investing.

Advisors turn to liquid alternatives because institutional- quality hedge funds present high barriers to entry. Crystal’s hedge fund portfolio services break down these barriers. Our comprehensive services help advisors become a full-service alternative investment firm providing their clients the opportunity to invest like the world’s largest investors. Our services include customized portfolios, low minimums, a roster of 70+ institu-tional-quality hedge funds vetted by our rigorous due diligence process, institutional safe guards, heightened transparency, portfolio construction tools, private label services, and more.


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Hedge Funds vs. Liquid AlternativesWhile liquid alternatives undoubtedly serve to benefit the liquidity-conscious in-vestor who may not be able to access hedge funds directly, hedge funds often outperform their liquid alternative counterparts by a number of different measures. As we compare liquid alternatives to hedge funds, we explore whether the liquidity benefits of these products outweigh the associated costs.

The Cost of Liquidity in an Illiquid WorldAlternative Investments, which are typically structured as private placements, are gener-ally considered illiquid investments as they can-not be actively traded in the marketplace with a readily known price. Hedge funds, however, fall on the more liquid segment of the Alternative Investment liquidity spectrum

The illiquidity of Alternative Investments, which in some cases can be a source of return, limits their attractiveness to investors; particularly the high net worth client who may be constrained by ongoing financial obligations such as funding a college tuition or simply the desire to retire and underwrite living expenses through both capital gains and income generated from an invest-ment portfolio.

Investors have increasingly turned to liquid al-ternatives as a means to expand their invest-ment universe while preserving a level of port-folio liquidity with which they have historically been comfortable.

This ability to turn-over a portfolio daily while providing access to differentiated sources of returns has been the primary contributor to the growth in the liquid alternatives industry.

The Reality of the Return Potential By and large, liquid alternatives have been mar-keted as a cost-effective means of extracting both outsized absolute returns as well as attrac-tive risk-adjusted returns in the marketplace. However, the ability to capture “alpha” in the market is exceedingly difficult and opportunities are largely exploited by the most sophisticated investors.

As a result, the most institutional-quality hedge funds have consistently earned above average rates of return that exceed those of liquid alter-natives.

For example, as depicted in Table 1, the average of Crystal’s top three Multi-Strategy Hedge Fund Candidates* delivered 12.02% in annualized re-turns over the past five years, while the average of the top three liquid alternative funds produced a meager 3.79% (see appendix for additional data points).

Additionally, investors in these institutional-quali-ty hedge funds were appropriately compensated for the level of risk assumed, as Sharpe ratios for the multi-strategy hedge funds on average exceeded 1.0 (see Table 1). The same cannot be said for those investors allocating to liquid al-ternative funds.


* Candidate Funds - Institutional-quality hedge funds that are offered through Crystal Capital Partners and that are * available for inclusion in a custom hedge fund portfolio.


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Limitations Imposed by Liquidity DemandsIn order to meet their daily liquidity require-ments, liquid alternatives are forced to severely limit the range of investment strategies they can pursue and are bound to the more liquid end of the hedge fund strategy spectrum.

Therefore, a majority of liquid alternatives sim-ply employ long/short equity, global macro, and/or managed futures strategies.

In comparison, the hedge fund industry consists of a much larger universe of strategies with some of the more compelling investment ap-proaches unavailable in a liquid alternative fund structure.

For example, distressed credit funds, which have produced attractive annualized returns of 11.1% over the past 3 years (HFRI Distressed/Restructuring Index for the period related to Jan. 2009 – Jul. 2012)* and are currently eager to exploit opportunities emanating from Europe, are unavailable in liquid alternative funds due to these liquidity constraints.

Dearth of Investment TalentWhile the liquid alternatives industry comprises of a few notable participants — namely Cliff As-ness’ AQR Capital Management — the hedge fund space has traditionally attracted the finest trading talent and the most intellectual individu-als across Wall Street.

With the inception of the Volcker Rule, as well as the fact that banks are limited in the amount of compensation they can reward, this reality has only intensified as of late. In fact, an increas-ing number of hedge funds have publicly com-mented that the hiring pool, particularly from the sell-side investment firms, has never been as abundant as it is today.

However, the liquid alternatives space is not ex-periencing a comparable influx of talent like their hedge fund peers as they are by and large con-fronted with the same challenges as the bulge bracket banks: the inability to offer double-digit payouts on profits and sizeable cash bonus to attract and retain talented personnel. **

Table 1: Top 3 Hedge Funds vs. Top 3 Liquid Alternative Funds by Return - 5 Year Statistics

5 Years

Multi Alternative Liquid Alt. Mutual Fund A 6.13% 7.19% 140.08% 17.08% 0.70 0.66 58.82%

Multi Alternative Liquid Alt. Mutual Fund B 2.88% 5.92% 117.44% 18.43% 0.31 0.75 66.18%

Multi Alternative Liquid Alt. Mutual Fund C 2.36% 14.01% 112.59% 35.53% 0.18 0.84 57.38%

Liquid Alts Average 3.79% 9.04% 123.37% 23.68% 0.40 0.75 60.79%

Crystal Multi-Strategy Hedge Fund A 13.70% 9.22% 206.99% 9.77% 1.31 0.16 66.18%

Crystal Multi-Strategy Hedge Fund B 12.76% 6.10% 197.45% 10.45% 1.81 0.31 82.35%

Crystal Multi-Strategy Hedge Fund C 9.60% 4.50% 168.07% 4.52% 1.80 0.03 77.94%

Hedge Funds Average 12.02% 6.61% 190.84% 8.25% 1.64 0.17 75.49%

Percent Months Positive

AnnualizedRoR

Standard Deviation

Cumulative Value

MaxDrawdown

SharpeRatio

Correl. to S&P 500

Timeframe: 2007 - Aug. 2012Source: Crystal Capital Partners from fund manager reporting, Morningstar MultiAlternative Index and Yahoo! Finance

* CrystalTools ©** Bloomberg Online: Billion-Dollar Traders Quit Wall Street for Hedge Funds, May 7, 2012


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Correlation to Equity MarketsIn an environment that has witnessed increasing correlations among all asset classes, seeking return streams that are uncorrelated to one another is of significant importance.

In fact, according to the 2011 Alternative Investment Survey of U.S. Institutions and Financial Advisors conducted by Morningstar and Barron’s Magazine,1 diversification and low correlation is the primary driver behind increasing ones strategic asset allocation to alternative investments.

Table 2 highlights the overwhelming diversification benefits that hedge funds offer, while liquid alter-natives approach a nearly perfect positive correlation to the S&P 500.

Downside Risk ProtectionThe market drawdowns experienced in 2008 are still quite vivid in the minds of investors to-day. When allocating capital to outside manag-ers, investors generally seek to understand how a fund performs in the face of market turmoil and how skilled a manager is at protecting in-vestor capital.

The growth in liquid alternatives however, only truly developed after 2008, at which time the industry was managing less than $40 billion in assets.1

Today, liquid alternative industry assets repre-sent $125.7 billion,2 resulting in a large universe of funds that have not obtained the necessary

Table 2: Correlation to S&P 500 - 5 years

Timeframe: 2007 - Aug. 2012Source: Crystal Capital Partners from fund manager reporting, Morningstar MultiAlternative Index and Yahoo! Finance

track record in order for them to be analyzed in relation to one of the worst market environ-ments of recent times.

Nonetheless, for the few pioneers of the liquid alternatives industry who can boast at least a 5 year track record, we can observe that Crystal’s Multi-Strategy Hedge Fund Candidates did a far superior job in protecting investor capital. *

As Table 1 reveals, not only was volatility signifi-cantly reduced but max drawdown figures were also considerably less than their liquid alterna-tive counterparts (see appendix for additional data points).

Multi-Strategy Hedge Fund A

HighCorrelationto S&P 500

Moderate Correlationto S&P 500

LowCorrelationto S&P 500

Multi-Strategy Hedge Fund B

Multi-Strategy Hedge Fund C

MSCIWorld

S&P 500Multi Alternative

Liquid Alt. A

Multi Alternative

Liquid Alt. B

Multi Alternative

Liquid Alt. C

0.16

0.31

0.03

0.97 1.0

0.660.75

0.84

Candidate Hedge Funds Liquid Alternatives Indicies

* See table 1 in appendix.


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ConclusionCrystal’s Multi-Strategy Hedge Fund Candidates clearly outper-form the leading liquid alternative funds.

Moreover, liquid alternatives are severely limited in the investment strategies they are able to pursue as well as the fact that the indus-try’s abbreviated track record ren-ders them unproven in market pe-riods when downside protection is of the utmost importance.

Additionally, liquid alternatives’ high correlation to the equity mar-kets calls into question their ability to diversify a portfolio.

For those qualified investors who are not constrained by liquid-ity pressures, institutional-quality hedge funds possess a much greater risk/reward pay off than the leading liquid alternative funds can offer. *


* Source: RAMIUS TRADING STRATEGIES LLC; The Emergence of Liquid Alternatives and the Case for Managed Future Mutual Funds, 2012 and Crystal Capital.


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1. Morningstar, Inc. “Morningstar & Barron’s 2011 Alternative Investment Survey of U.S. Institutions and Financial Advisors.” May 2012. http://corporate.morning-star.com/us/documents/MarketResearchSurveys/MorningstarBarrons2011Survey.pdf

2. Goodman, Beverly. “An Alternative to Hedge-Fund Alternatives.” Barron’s Magazine. 26 May 2012. Print.

Appendix: Additional Data Points

Top 10 Morningstar MultiAlternative Index by Return - 5 Year Statistics

Top 10 Crystal Capital Partners Multi-Strategy Hedge Fund Candidates by Return - 5 Year Statistics

Timeframe: 2007 - Aug. 2012Source: Crystal Capital Partners from fund manager reports

Timeframe: 2007 - Aug. 2012 Source: Morningstar MultiAlternative Index and Yahoo! Finance Morningstar and Yahoo! Finance

5 Years

Multi Alternative Liquid Alt. Mutual Fund A 6.13% 7.19% 140.08% 17.08% 0.70 0.66 58.82%

Multi Alternative Liquid Alt. Mutual Fund B 2.88% 5.92% 117.44% 18.43% 0.31 0.75 66.18%

Multi Alternative Liquid Alt. Mutual Fund C 2.36% 14.01% 112.59% 35.53% 0.18 0.84 57.38%

Multi Alternative Liquid Alt. Mutual Fund D 2.03% 9.69% 111.87% 27.16% 0.14 0.87 56.72%

Multi Alternative Liquid Alt. Mutual Fund E 0.86% 14.79% 104.98% 40.33% 0.05 0.91 58.82%

Multi Alternative Liquid Alt. Mutual Fund F 0.49% 12.03% 102.81% 31.72% 0.00 0.85 58.82%

Multi Alternative Liquid Alt. Mutual Fund G 1.07% 10.86% 106.22% 32.85% 0.04 0.73 63.24%

Multi Alternative Liquid Alt. Mutual Fund H 0.52% 14.97% 102.98% 45.08% 0.03 0.92 52.94%

Multi Alternative Liquid Alt. Mutual Fund I 0.43% 5.11% 102.37% 11.90% -0.09 0.45 56.92%

Multi Alternative Liquid Alt. Mutual Fund J 4.04% 5.79% 116.41% 10.06% 0.69 0.79 67.39%

Liquid Alts Average 2.08% 10.04% 111.78% 27.01% 0.21 0.78 59.72%


AnnualizedRoR

Standard Deviation

Cumulative Value

MaxDrawdown

SharpeRatio

Correl. to S&P 500

5 Years

Crystal Multi-Strategy Hedge Fund A 13.70% 9.22% 206.99% 9.77% 1.31 0.16 66.18%

Crystal Multi-Strategy Hedge Fund B 12.76% 6.10% 197.45% 10.45% 1.81 0.31 82.35%

Crystal Multi-Strategy Hedge Fund C 9.60% 4.50% 168.07% 4.52% 1.80 0.03 77.94%

Crystal Multi-Strategy Hedge Fund D 8.81% 3.91% 161.36% 6.40% 1.88 0.41 80.88%

Crystal Multi-Strategy Hedge Fund E 6.48% 17.60% 142.72% 18.49% 0.38 0.52 77.94%

Crystal Multi-Strategy Hedge Fund F 6.31% 10.59% 141.41% 54.94% 0.52 0.10 55.88%

Crystal Multi-Strategy Hedge Fund G 5.23% 6.90% 133.47% 12.64% 0.60 0.15 55.88%

Crystal Multi-Strategy Hedge Fund H 4.93% 5.01% 124.20% 6.28% 0.92 -0.10 62.96%

Crystal Multi-Strategy Hedge Fund I 4.92% 6.79% 131.28% 17.12% 0.57 0.32 63.24%

Crystal Multi-Strategy Hedge Fund J 4.80% 5.90% 130.44% 16.93% 0.62 0.61 69.12%

Hedge Funds Average 7.75% 7.65% 153.74% 15.75% 1.04 0.25 69.24%


AnnualizedRoR

Standard Deviation

Cumulative Value

MaxDrawdown

SharpeRatio

Correl. to S&P 500

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DEFINITIONS:

MSCI World Index tracks the stocks of approximately 1,300 companies representing the stock markets of 22 countries.

The S&P 500 consists of 500 stocks chosen for market size, liquidity and industry group representation. Each stock’s weight in the index is proportionate to its market value. The S&P 500 is one of the most widely used benchmarks of US equity performance.

Cumulative Value time value of money is the value of money figuring in a given amount of return for a given amount of time. For example 100 dollars of today’s money held for a year at 5 percent interest is worth 105 dollars. The Cumulative value is therefore the value of money after several periods of returns: 100 dollars invested now would be worth 100 * (1+ x1%) after a period that returned x1%, would be worth 100 * (1+x1%)*(1+x2%) after the second period and so on.

The Volcker rule separates investment banking, private equity and proprietary trading (hedge fund) sections of financial institutions from their consumer lending arms. Banks are not allowed to simultaneously enter into an advisory and creditor role with clients, such as with private equity firms. The Volcker rule aims to minimize conflicts of interest between banks and their clients through separating the various types of business practices financial institutions engage in.

Standard deviation reflects a portfolio’s total return volatility, which is based on a minimum of 36 monthly returns. The larger the portfolio’s standard deviation, the greater the portfolio’s volatility.

Max drawdown is an indicator of the risk of a portfolio based on a certain strategy. It measures the largest single drop from peak to bottom in the value of a portfolio (before a new peak is achieved).

Sharpe ratio is calculated by subtracting the risk-free rate – such as that of the 10-year U.S. Treasury bond – from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed.

IMPORTANT DISCLOSURES:

This Document is for informational purposes only and is not an offer to sell or the solicitation of an offer to buy an interest in any of the Funds managed or advised by Crystal Capital Partners, LLC (“Crystal”). This document contains only summary information about the Funds and is qualified in its entirety by, and should be read in conjunction with, the more detailed information contained in the Offering Memorandum for each Fund.

The interests in the Fund have not been registered with the SEC under the Securities Act, or under the securities laws of any state of the United States or under the securities laws of any other jurisdic-tion, and the Funds have not been registered as an investment company under the Investment Company Act of 1940, as amended, and are being offered and sold in reliance on exemptions from the registration requirements of such laws.

The information contained in this Document has been prepared to assist interested parties in making their own evaluation of the opportunity and does not purport to be complete or to contain all of the information that a prospective investor might consider important in connection with an investment in the Fund. In all cases, interested parties should conduct their own investigation and analysis of the Fund, the data set forth in this Document and such other data as they may consider relevant to an investment decision. The information contained in this Document does not constitute legal, tax, account-ing, regulatory or investment advice, and persons considering an investment in the Fund should consult their own legal and financial advisors with respect to the application of United States securities, tax or other laws and accounting and regulatory provisions to their particular, as well as any consequences arising under the laws of any other jurisdiction.

The liquidity schedule constitutes the “best available” liquidity as of the date hereof. The liquidity terms described are for a particular exposure. From time to time, the Fund and/or the Outside Portfolio Manager may offer different liquidity terms. “Best available” liquidity assumes availability when soft lock terms are applicable.

The pro forma results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.

THE PRO FORMA COMPOSITE PERFORMANCE RECORD IS HYPOTHETICAL AND THESE TRADING ADVISORS HAVE NOT TRADED TOGETHER IN THE MANNER SHOWN IN THE COMPOSITE. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY MULTI-ADVISOR MANAGED ACCOUNT OR POOL WILL OR IS LIKELY TO ACHIEVE A COMPOSITE PERFORMANCE RECORD SIMILAR TO THAT SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN A HYPOTHETICAL COMPOSITE PERFORMANCE RECORD AND THE ACTUAL RECORD SUBSEQUENTLY ACHIEVED.

ONE OF THE LIMITATIONS OF A HYPOTHETICAL COMPOSITE PERFORMANCE RECORD IS THAT DECISIONS RELATING TO THE SELECTION OF TRADING ADVISORS AND THE ALLOCATION OF ASSETS AMONG THOSE TRADING ADVISORS WERE MADE WITH THE BENEFIT OF HINDSIGHT BASED UPON THE HISTORICAL RATES OF RETURN OF THE SELECTED TRADING ADVISORS. THEREFORE, COMPOSITE PER-FORMANCE RECORDS INVARIABLY SHOW POSITIVE RATES OF RETURN. ANOTHER INHERENT LIMITATION ON THESE RESULTS IS THAT THE ALLOCATION DECISIONS REFLECTED IN THE PERFORMANCE RECORD WERE NOT MADE UNDER ACTUAL MARKET CONDITIONS AND, THEREFORE, CANNOT COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FURTHERMORE, THE COMPOSITE PERFORMANCE RECORD MAY BE DISTORTED BECAUSE THE ALLOCATION OF ASSETS CHANGES FROM TIME TO TIME AND THESE ADJUSTMENTS ARE NOT REFLECTED IN THE COMPOSITE.

The Fund and/or the Fund Manager use several sources of information to support the analysis in this Document, including information provided by investment managers, third party databases, and other public and non-public sources. The Fund and/or the Fund Manager will make commercially reasonable efforts to ensure the reliability of the information, but make no warranty as to the accuracy, completeness or suitability of the information. Such information is further subject to the qualifications and limitations contained in the Terms of Use Agreement and the Disclaimer made part of each fund report.

The interests in the Fund are speculative, illiquid, involve substantial risk, and are a suitable investment only for a limited portion of an investor’s portfolio. Investors could lose all or substantially all of their investment in the Fund. Neither the delivery of this Document nor any offers or sales hereunder shall create an implication that there has been no change since the date of this Document or the Offering Memorandum in the matters disclosed herein. Before you decide to invest, read the entire Offering Memorandum for the specific fund of interest carefully, and in particular, consider the “Risk Factor” section. If you, or your advisors, have questions concerning the operations, you should contact the Fund Manager at the address or phone number included in the Offering Memorandum.

None of the directors, officers, employees or advisers of Crystal or its affiliates or any other person makes any promise, guarantee, representation or warranty (expressed or implied) to any person as to the fairness, accuracy or completeness of this Document or the information contained herein, or of any other information, materials or opinions, whether written or oral, that have been, or may be, prepared or furnished by any of those companies, including, without limitation, economic or financial projections, if any, or risk evaluations.

The recipient acknowledges and agrees that all of the information contained herein is confidential, and if the recipient has previously accepted this Document, signed or agreed to Crystal’s Terms of Use Agreement or Non-Disclosure Agreement, is subject thereto. Without limiting the generality of the foregoing: (1) the recipient will not reproduce this Document, in whole or in part; (2) if the recipient does not wish to pursue this matter or is not an “Accredited Investor” within the meaning of Rule 501(a) under the Securities Act of 1933 and/or a “Qualified Purchaser” as such term is defined in the Investment Company Act of 1940, as amended and (the “Securities Act”), it must return this Document to Crystal, as soon as practicable, together with any other materials relating to the Fund, which the recipient may have received, or must destroy this Document and such other materials as soon as practicable and, in each case, must destroy, as soon as practicable, all copies of analyses, compilations, studies or other documents prepared by it in connection with any information in this Document or such other materials.

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Hedge Funds vs. Liquid Alternatives

Economy & Finance