Morningstar Advisor - February/March 2013 - (Page 27)

The real/nominative choice can also have an impact on portfolio construction itself. For example, a low-inflation climate is likely to be friendlier to an absolute-return strategy that invests for nominal return. Yet, it stands to reason that most bond-heavy “conservative” portfolios would also fare well in such a climate, which presents a quandary—why resort to absolute return when bonds will do? The answer might be to build an absolutereturn strategy that invests in lower-volatility arbitrage strategies that are less levered to interest rates and inflation, thereby enhancing diversification. On the flipside, when inflation is on the upswing, equity-like strategies such as opportunistic long/short and real assets are more likely to come in handy. Exhibit 1 Two Sample Portfolios: Absolute Return and Real Return Broad Category Discipline Alternative Strategies Convertible Arbitrage 6 4 Covered Call 5 3 Credit Arbitrage 9 — Currency Long/Short 9 7 Distressed Debt 1 — Equity Long/Short 11 — Market Neutral 4 — Merger Arbitrage 9 — Bank Loans — 17 Global Equity 19 12 Traditional Strategies High-Yield Bonds 3. Diversification or Upside? Hyperbole aside, most alternative mutual funds have proved to be pretty mediocre diversifiers. To illustrate, Exhibit 2 plots the median since-inception one-year correlation of returns for alternative mutual funds to the broad U.S. stock and bond markets. (In other words, we tallied up rolling one-year correlations to Real Return (% Assets) 8 — 17 Investment-Grade Bonds/Cash 20 1 4 11 Foreign Bonds/Currencies — 15 Global Real Estate — 5 100 Diversifying Agents 3 Inflation-Protected Bonds Potential Solution: Construct Two Models We offer two different nontraditional models. (Exhibit 1 shows a sample.) One is geared toward nominal returns (absolute return), and the other more explicitly targets positive returns after inflation (real return). The portfolio-construction approaches are distinct. Our absolute-return model invests in a grab bag of assets and disciplines, including traditional and non-traditional approaches, with an eye toward muting volatility and boosting diversification. For its part, the real-return model allocates more heavily to areas like commodities, TIPS, and bank loans, is less concerned with downside avoidance, and tends to be more correlated with the stock and bond markets. We split the two apart not because the goals of each portfolio are wholly incompatible, but rather because we felt that we could better differentiate and, thus, convey the objectives and attributes of each model to clients. Absolute Return (% Assets) 100 Commodity Futures Total Exhibit 2 Alternative Funds: Median One-Year Correlation of Returns Based on Rolling Returns, January 1990 to December 2012 Long/Short Equity Managed Futures Market Neutral U.S. Bond Market U.S. Stock Market 60% U.S. Stocks/40% U.S. Bonds Multialternative Correlation to U.S. Bond Market 1.0 0.8 0.6 0.4 0.2 0.0 –0.2 –0.4 –0.6 –1.0 –0.8 –0.6 –0.4 –0.2 0.0 0.2 0.4 0.6 0.8 1.0 Correlation to U.S. Stock Market For illustrative purposes only. MorningstarAdvisor.com 27 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2013

Morningstar Advisor - February/March 2013
Contents
Contributors
Letter From the Editor
Social Media, the Old- Fashioned Way
Do You Use Active Strategies?
Youth Appeal
How to Buy the Unloved 2013
Morningstar Managers of the Year
Investments á la Carte
Investment Briefs
Approaches to Absolute-Return Investing
In Agriculture, It’s Good to Be Strong
Yes, There Are Good Active Funds
The Decoupling
Where It Could Pay to Be Active
The Active Fund That Defies Obsolescence
The Epitome of an Active Manager
Lines of Communication
The Existence of Market Timing ‘Intelligence’
A Route to Commodities that Bypasses the Futures Market
Best Positioned for Health-Care Reform
Diversified Stock Funds That Earn Their Stars
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
A Twisted Debate

Morningstar Advisor - February/March 2013