Chasing Two Rabbits: Challenges in Benchmarking Liquid Alternatives

Abstract

Liquid alternatives are required to compare their performance to a broad-based market index. Despite their objective to offer low correlations with equity returns, these funds provide traditional equity indexes as benchmarks two and a half times more than any other benchmark category. By pursuing strategies unrelated to their primary benchmarks, liquid alternatives can generate significant tracking errors, which cause biased information ratios. We review the challenges of benchmarking liquid alternatives and recommend use of the downside deviation or maximum drawdown. This issue is important, as research shows how performance relative to even a mismatched benchmark is a significant determinant of fund flows.