Morningstar Magazine - February/March 2018 - 32

Spotlight: Alternative Funds

fund. Everything is the same between these two
portfolios except the alternative fund has
a 0.25 lower correlation to the 60/40 allocation.
Bank-loan funds have an average fee of 0.85%.
What should an investor be willing to pay
for the lower correlation benefit of the long-short
credit fund? To find out, we calculated the Sharpe
ratio on both portfolios. We mathematically
back out the fee for the alternatives fund as if the
Sharpe ratios of the two portfolios were the same.
This would be the maximum anyone would want
to pay for the long-short credit fund. However,
we'd argue that investors should pay much less to
have an adequate margin of safety. We found
that the most an investor should pay for the 0.25
lower correlation was 1.4%, given our assumptions.
The average long-short credit fund costs 1.35%.
But 20% of the funds in the category charge less
than 1%, so lower-cost options certainly exist.
Improving the Odds

Now, we turn to alpha. Some alts funds will
justify their fees. To improve our chances of finding
one, we can average each alternative category's
alpha. Our study used a Fama-French threefactor model for equitylike categories, a two-factor
(credit and duration) model for bondlike
categories, and a mix for multialternative funds.
We only looked at funds with at least a threeyear track record and included dead funds
to avoid survivorship biases. We ran our calculations from inception.
Here are the results of our study:
Alpha by Category

%

Long-Short Credit

1.81

Long-Short Equity

0.03

Market Neutral

2.38

Multialternative

-1.21

Nontraditional Bond

1.70

Option Writing

1.05

Source: Morningstar Direct.

The results jibe with many well-established
investment truisms, such as that equity investing
tends to be a zero-sum game. We stated
that long-short equity managers as a whole don't
add much alpha in the period we studied. Indeed,
the average long-short equity fund generated
nearly zero alpha. Markets are extremely
competitive, and adding the ability to sell stocks
short doesn't appear to give managers a new
competitive edge; shorting is just as difficult, if not
more difficult, as long bets.
Another investment mantra for many is that there
are more active opportunities in fixed income.
We also found this to be the case with alternatives.
But we were a bit surprised by the results.
We expected to see some modest alpha for the
nontraditional bond category, as certain
funds take on international exposure that isn't
fully captured by our simple models. However, we
were surprised to see long-short credit funds
generating approximately 1.8% alpha. That group is
more U.S.-centric, so the results are compelling;
however, the category is small, so sample size may
be a factor.
Our results also showed that market-neutral funds
generated the highest alpha at around 2.4% per
year. A few caveats are necessary, however. We
report all these numbers gross of fees4 because we
believe it's important to first establish which
categories might have an inherent advantage
to offer manager skill, and which do not. Including
fees can cloud that picture. But fees are still an
important consideration. For market-neutral funds,
fees tend to be high, averaging around 1.76%.
However, it's important to stress that lower-cost
options exist and paying over two thirds the
category's historical alpha in fees wouldn't likely
be advisable. Finally, returns in this space
tend to be mostly alpha, meaning that while in
other categories investors can still generate
returns absent of alpha, in market-neutral land,
alpha generation tends to drive returns.

While we wouldn't have been surprised to
see the category generate zero alpha, perhaps our
models' negative 1.2%-per-annum assessment
is too bearish. These funds can have momentum
and other features baked in that we left out
for simplicity (and momentum has performed
poorly recently). Still, the negative alpha isn't ideal,
especially once fees are accounted for.
Finally, option-based funds in our study generated
about 1% alpha, better than long-short equity,
but worse than fixed-income categories that generated lower returns overall (so alpha per unit
of returns is higher for fixed income). With fees
hovering around 1.55%, these funds appear to be
charging a lot more than they're worth.
Alpha as a Guide

Investors can use these category average
alpha figures to help guide their investment
decision-making process. Categories with
less-than-stellar track records of generating alpha
should be viewed more cautiously, while
those with higher potential could have more
opportunities. As mentioned, however,
alpha is only part of the story. The full spectrum
of opportunity should be thoroughly scrutinized
when analyzing alternatives. For example,
the diversification power of other assets should
also play a key role in decision-making.
That is why the ability to separate alpha potential
from passive beta exposures is so important;
it helps to broaden the opportunity set. Similarly,
categories such as market-neutral can offer
higher alpha potential but have lower-return
profiles overall, so while alpha may be a
good way to measure risk-adjusted outperformance, alpha alone can't tell us how to make
asset-allocation determinations. K
Josh Charney, CFA, is a senior investment analyst,
outcome-based strategies, with Morningstar Investment
Management, LLC.

Multialternative funds take on an array of
exposures and international positions, as well.

4 We chose to run our study gross of fees because fees can muddy the performance appraisal waters. By casting fees aside, it is easier to discern the categories where managers have added
alpha. Armed with that information, investors can better gauge what fee levels are more appropriate.

32

Morningstar February/March 2018



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