This trend may be attributed to modern portfolio theory, which states that risk-adjusted returns can be enhanced by adding asset classes that have low or negative correlations to the rest of a portfolio. That means alternative funds in a client's portfolio should zig when her traditional stocks and bonds zag.
This would seem to be attractive to a planner formulating a portfolio. Unfortunately, an analysis of Morningstar data indicates that most alternatives have been producing significant negative returns, and seem likely to continue recording losses.
Morningstar defines an alternative investment as any fund or ETF that falls into one or more of the following three buckets:
* Nontraditional asset classes (such as commodities and currencies).
* Nontraditional strategies (such as shorting or hedging).
* Illiquid assets (private equity, private debt).
Morningstar notes that once an investment enters the mainstream, it is no longer considered an alternative investment. To be considered a good alternative investment, according to the research giant, a category must produce positive, risk-adjusted returns over a reasonable time frame and exhibit low correlations to traditional investments.
Using these definitions, Morningstar developed seven classifications of alternatives.
There are three alternative categories that involve equities: Long-short equity funds are the largest category and are typically long stocks, with betas typically between 0.3 and 0.8. Market-neutral funds hedge out most of the market risk and have betas between minus 0.3 and plus 0.3. Bear market funds take a net short exposure to stocks and often use leverage.
There are also three alternative funds that are based on derivatives: Managed futures funds take long and short bets on futures contracts in such areas as energy or food commodities. Currency funds invest in currency futures and forwards. Volatility funds trade equity options betting that market volatility will either increase or decrease. There are currently no volatility mutual funds, but an example of a volatility ETF is the iPath S&P 500 VIX Short-Term Futures fund.
The seventh category is the nontraditional bond fund. These funds invest in all types of debt, but hedge duration risk or credit risk, or both. In addition, while it is not a pure category, Morningstar classifies funds that use multiple strategies as multi-alternative funds.
Because these strategies are all active to extremely active, they have high expense ratios averaging 1.82% annually. These expenses exclude many operating costs such as the costs of the hedges used in their portfolios.
While all of these strategies sound sophisticated and intuitively appealing as a whole, they haven't worked in aggregate. Many achieve their goal of low and negative correlations, but fail to produce positive returns. Only managed futures and nontraditional bonds have produced positive five-year returns, and these were less than 2% annually. In the last year, the only positive result was posted by nontraditional bonds, 0.51%, and the worst loss was in managed futures, which dropped 7.22%. In fact, the categories combined for one-, three- and five-year losses.
Not only were returns dismal, most categories failed to deliver much in the way of diversification to a moderate-risk portfolio of 60% stocks (as represented by the S&P 500) and 40% fixed income (Barclays Aggregate Bond). In fact, long/short equity and multi-alternative funds had correlations near 1. Only managed futures and bear market funds had negative correlations. There is no data for the volatility category since there are no mutual funds.
EXPLAINING THE LOSSES
When you look under the hood of many of these strategies, the losses generated are not surprising. It's not unreasonable to conclude that losses are likely to continue for most of these categories. Consider this outlook for each category:
Long/short equity funds would be expected to return the risk-free rate (currently about 0) if they were perfectly hedged. But because they have a beta averaging 0.6, they should return the risk-free rate plus 60% of the market risk premium. Over the past three years, the Wilshire 5000 total return was 15.5% annually, meaning that this strategy should theoretically have returned about 9.3% annually. Yet it produced only a 2.58% return because of the 2.02% expense ratio and very high hedging costs. Morningstar used the Mars Hill Global Relative Value ETF (GRV) as a proxy for this category, even though late last year that fund went defunct after large losses. Positive long-run returns can be expected if the funds keep positive betas, although investors will be giving away most of the returns in fees.