Investors have been pouring money into alternative mutual funds and ETFs in recent years, with assets soaring to $280billion in April from about $80 billion at the end of 2007.
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.
The picture is not so bright for market-neutral funds. These are similar to long/short funds but hedge out all of the market risk, aspiring to a beta of zero. As the capital asset pricing model illustrates, these funds should return the risk-free rate before costs. The increasing losses are consistent with a declining risk-free rate. Even the Vanguard Market Neutral Fund (VMNFX), which has a low 0.25% expense ratio, has lost 3.87% annually over the same five-year period. With such a low risk-free rate, this category is likely to continue churning losses.
BEAR MARKET PROBLEMS
Bear market funds are even more problematic, and Morningstar concludes they are not good long-term investments. These funds were hit badly during the three-year bull market, losing 22.3% annually. But they lost 12.5% annually during the five-year period, when U.S. stocks overall actually fell slightly. This is because of the use of leverage, which punishes for volatility as the geometric average varies more from the arithmetic average (that's why a 50% gain following a 50% loss doesn't, of course, break even). In 2011, both the ProShares S&P 500 triple-leveraged short and triple-leveraged long funds lost money.
Owning stocks long in one part of a portfolio and shorting in another can often be like going to the roulette table and betting on both odd and even numbers. You come out even except when the house takes it all when either 0 or 00 shows up after a spin.
Examining derivative funds, the managed futures category had some success early on but lost 7.22% in the last year. These funds generally use momentum strategies, such as betting the price of oil will continue to go up faster than the market thinks. It's important to note that, in the aggregate, not a penny has ever been made in the futures market. If someone sells an oil future, someone else has to buy it, even if it's a market maker like the Chicago Board Options Exchange. Proponents of this strategy point to certain parties, like airlines, that are willing to pay an insurance premium to fix the price of a key commodity, like jet fuel. This is dubious in the absence of readily available studies. Thus, the expected return of this category is a pure zero before trading costs, and the 2.73% annual expense ratio is the highest of all alternative categories.
Terry Tian, an alternative investments analyst at Morningstar, disagrees that managed futures funds should have an expected return of zero before costs. He notes that currency futures alone have a $4 trillion daily trading volume and that managed futures make up a small amount of this trading and can deliver positive returns. He believes the strategy can exploit traders' behavioral biases. Tian points out that the Morningstar MSCI Systematic Trading Hedge Fund Index has generated returns greater than the total returns of the S&P 500 since 1996. He does concede that the hedge fund database suffers from self-reporting bias, but feels strongly that the strategy itself is valid.
Currency funds have also generated consistent negative returns but have had an especially bad showing in the past year, losing an average of 5.68%. This may be because conventional wisdom fell on its face; it was assumed that the U.S. dollar was going to take a beating, but it actually surged. Trading currency futures and forwards is also a zero-sum game before costs. For every dollar bet against one currency, there is another bet long on the same currency. Tian notes that these funds can also own foreign debt but must hedge away the duration. This strategy can earn the risk-free rate, which is currently near zero.
The nontraditional bonds category has achieved positive returns over the past one-, three- and five-year periods. Unfortunately, the returns have been quite small compared with the Barclays Aggregate Bond Index. For example, the category returned 1.66% annually over the five-year period, while the bond index returned 6.63% annually. The use of derivatives to manage interest rate risk resulted in lowering returns.
The last category, multi-alternative funds, used multiple strategies yet actually provided little diversification, with a 0.94 correlation to the moderate stock/bond portfolio. This class turned in losses over the past one and five years. Curiously, it returned 4.23% annually over the three-year period, possibly benefiting from the three-year bull market for both stocks and bonds.
HIGH COSTS, TOO FEW WINNERS
Financial planners strive to help clients minimize risk, and alternatives seem to be an answer. But Morningstar data shows that investing in these alternatives has resulted in losses. While this analysis has simplified the descriptions of the strategies that these fund categories use, future losses for most categories seem very likely. And though long/short equity, nontraditional bonds and multi-alternative funds may generate long-term gains, these gains are likely to be modest.
This doesn't mean there aren't specific funds within each category that have had handsome returns. Even in zero-sum game categories, some funds must be winners. Tian believes Morningstar's new forward ratings can identify good funds for investors and that, by picking the right funds, an advisor can improve the risk-adjusted return for a client's portfolio.
While some of these strategies are better than others, all have high costs and, in the aggregate, have turned in negative or low returns. This is a consideration that must be taken into account when constructing portfolios.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct faculty member at the University of Denver.
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