Morningstar Magazine - February/March 2018 - 34

Spotlight: Alternative Funds

Mapping Alternatives
Where these funds land in the style box
reveals their diversification benefits.

to a wide range of outcomes over any
period. These differences appear more plainly
when viewed through the alternatives
style box ( EXHIB IT 2 ).
Using this information, investors can better
assess a long-short fund's diversification
characteristics, which facilitates comparison and
more-refined analysis.
Allocation Decisions

STYLE BOX

Jason Kephart

Alternative strategies come in many different
varieties, and funds within the same Morningstar
Category that pursue very similar strategies
can still have very different diversification
characteristics. To help investors gauge a fund's
diversification potential, we launched
the Morningstar Style Box for alternative funds
in October 2016. This research framework,
now available in Morningstar Direct, allows
investors to quickly and intuitively evaluate liquid
alternatives investments.
In this article, we use the alternatives style
box to demonstrate the importance of
making good comparisons and conducting
thorough evaluations when analyzing alternative
investments. We take a bottom-up look at the
alternatives universe by placing each liquid
alternative fund into one of the style box's nine
regions. We find significant diversity among
alternative strategies, even among those in the
same Morningstar Category.

global equities based on the trailing three years
of monthly returns ( EXHIB IT 1 ).
The dispersion of liquid alternative strategies
within the alternatives style box is obvious.
What's more striking, however, is the dispersion
within each Morningstar Category. Take the
long-short equity Morningstar Category,
for example. To be included in that category, funds
must invest solely in equities, have at least
20% gross short exposure on a consistent basis,
and maintain an equity market beta between
0.3 and 0.8. But within those constraints, there
is a lot of room for flexibility, which can lead

EXHIBIT 1

Of Every Stripe When plotted on the
style box, the diversity of alternative
funds becomes clear.
Long-Short Credit
Long-Short Equity
Managed Futures
Market Neutral

Multialternative
Multicurrency
Option Writing
Correlation
1.0

A Varied Universe

Many alternative strategies derive their appeal
from the potential to improve a traditional portfolio
by further diversifying it, either by delivering
an uncorrelated return stream or by dampening
volatility and reducing downside. In practice,
determining whether an alternative strategy can
deliver those benefits can be a challenge
for investors. The alternatives style box makes it
easier to evaluate the diversification benefits
a liquid alternative mutual fund has conferred over
time. The style box plots alternative funds
based on correlation and relative volatility to

34

Morningstar February/March 2018

0.5

0.0
-0.5
0.00
0.33
Relative Volatility

0.66

Source: Morningstar Direct. Data as of 07/31/2017.

1.00

The alternatives style box forms along two
dimensions. The x-axis depicts a fund's volatility
over the trailing three years compared with
that of the Morningstar Global Equity Markets
Index. The y-axis measures the correlation
to global equities. By plotting funds along both
dimensions, we can place them in the appropriate
region of the alternatives style box. While this
is not a substitute for a complete research process,
the alternatives style box can make it easier
to detect subtle differences like these between
funds using similar investment strategies.
An example can help illustrate this concept
and how investors can use the style box to make
more informed decisions on how to use an
alternative fund in a traditional portfolio. Take,
for example, AQR Multi-Strategy Alternative ASAIX
and Goldman Sachs Absolute Return Tracker
GJRTX, two funds with Morningstar Analyst
Ratings of Bronze in the multialternative category
that seek to outperform broad hedge fund
indexes. Despite having similar return goals and
volatility levels, the funds have very different
diversification characteristics, which investors can
easily spot in the alternatives style box ( EXHIBIT 3 ).
AQR Multi-Strategy Alternative's management
team fully hedges its portfolio of alternative
strategies so there is no long bias toward equities.
Of course, that doesn't mean that over short
time periods the fund can't rise or fall at the same
time as equities, but it has shown that over
longer periods it does have a low correlation
to equity markets. Over the three years ending July
31, its correlation to global equity markets
was negative 0.31. An investor using the style box
can take the negative correlation to mean
that the fund's returns over that period were not
driven by equities. In fact, over this three-



Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2018

Contents
Morningstar Magazine - February/March 2018 - Cover1
Morningstar Magazine - February/March 2018 - Cover2
Morningstar Magazine - February/March 2018 - 1
Morningstar Magazine - February/March 2018 - 2
Morningstar Magazine - February/March 2018 - Contents
Morningstar Magazine - February/March 2018 - 4
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