Updated Wednesday, July 30, 2014 as of 9:21 PM ET
Why Benchmarking Alts Can Prove Them Obsolete
Thursday, July 24, 2014
Partner Insights

Benchmarking alternatives that fit in clientsí portfolios can be tricky. But for some alternatives, once you consider the benchmark, the more difficult part is justifying the investment's place in the portfolio.

Here are some alternatives where the logical benchmark can lead to the conclusion that they have no role in a portfolio.


Market neutral funds try to match short and long positions to achieve a beta near zero. Morningstarís criteria is that the beta exposure be between -0.3 and +0.3. The Capital Asset Pricing model shows that a zero beta fund should be expected to earn the risk free rate of a short-term Treasury bill, which is currently close to zero. Since an investment with an expected return of cash with far more volatility would be hard to argue was appropriate for a client, one should think twice before putting a client in such a fund. If you do believe they can generate a net alpha, then define that expected annual alpha.


Managed futures are easy to benchmark. The expected return before fees is zero as not a penny has ever been made, in the aggregate, in the futures or options market. They are a zero sum game before costs and Morningstar shows the five year returns averaging a -2.47% annually.

Explaining this to a client quickly eliminates this alternative. The futures markets are great for businesses to manage risk but fail the pure investment test.


Currency funds invest in short-term money markets of foreign currency or in forward contracts or swaps. As previously discussed, short-term yields are near zero and the forward contracts are the same zero sum game. Thus, itís not surprising that three year returns are negative and five year returns are a modest 1.98% annually, according to Morningstar.


Finally, bear market and levered bear market funds can give downside protection and the benchmark is obvious in that it should give the downside protection bargained for. But the role of the bear market fund is somewhat illogical if you also have the client invested long in the market.

How do you explain benchmarking large cap stocks against the total return of the S&P 500 and the levered short S&P 500 fund on three times the loss of the same index? Thatís like betting on both teams in a Super Bowl game. Itís not a smart bet, yet I see it too many times.


If you do use these alternative funds for clients, itís critical to come up with an alternative benchmark. It would not be appropriate to benchmark against the category if the category is flawed.

For example, the Durham Alternative Strategy Fund (DCASX) lost only 0.24% annually over the past five years compared to a managed futures category average loss of 2.47%, but it may be hard to argue to the client that they should be happy with this loss. A better benchmark would be a simple weighting of low cost stock and bond funds giving a similar standard deviation to the fund being benchmarked.

And remember, the benchmarks Iím suggesting are extremely subjective. The main goal is to help advisors think about the composition of the alternative assets and determine their role in clientsí portfolios. The more difficult the benchmark, the less likely that it belongs in a portfolio. If you canít explain the fund to your client, perhaps you should rethink using it.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.

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(1) Comment
To be honest, I am quite skeptical about most alternative and their ability to deliver risk adjusted returns in products that offer daily liquidity. However, these "benchmarks" of Mr. Roth's are some sort of a bad joke. While Mr. Roth says the benchmark for managed futures is zero minus the expenses, here are the facts of the Barclays CTA index going back to January 1980.

Compound Annual Return 10.23% Sharpe Ratio 0.38 Worst Drawdown 15.66% Correlation vs S&P 500 0.01 Correlation vs US Bonds 0.13 Correlation vs World Bonds 0.00

Does that look like zero minus expenses? This index has been negative the past 3-4 years which corresponds to the period these products have been available in mutual funds. Applying inappropriate benchmarks to anything is a waste of time, pure and simple.

Posted by Ted S | Tuesday, June 24 2014 at 2:41PM ET
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