Morningstar Magazine - February/March 2018 - 36

Spotlight: Alternative Funds

in this square of the style box by Morningstar
category as of July:
Multialternative

Market Neutral

Long-Short Credit

Option Writing

Long-Short Equity

Highly correlated, less-volatile alternative funds
are often considered as a partial stand-in
for fixed income, which has a similar risk/reward
profile. Over the measurement period in this
example, the Bloomberg Barclays US Aggregate
Bond Index had 27% of the relative volatility
of global equities, for example.
These funds' high correlation to equities
should give investors pause, though, as it indicates
performance tends to be influenced by the
direction of global stocks. In a market where
stocks are falling, these strategies are likely to fall
as well, albeit less given their lower relative
volatility. Still, investors who have turned to these
funds in lieu of fixed income amid concern
about rising interest rates should keep in mind that
they could disappoint in an equity market
sell-off, during which it's not uncommon for bonds
to rally. In such a scenario, they'd probably
be better off in bond funds.
Over the three years ending July 31, for example,
the average high-correlation/low-volatility
alternative fund captured 22% of the global equity
benchmark's downside, but bonds tended to
deliver gains. The Bloomberg Barclays US
Aggregate Bond Index gained 12% during those
down periods over the same span.
These funds may still appeal to more conservative
investors, though even they should be mindful
of how they'll mesh with other holdings as part of
a broader portfolio. For investors willing to take the
plunge, there are a handful of funds with these
characteristics that we recommend ( E X H I BI T 5 ).
Alternative Funds With High Correlation and High
Relative Volatility
In the top right portion of the alternatives style

Morningstar February/March 2018

box are liquid alternative funds that are highly
correlated with global equities and relatively
volatile. These funds hail predominantly from the
long-short equity category. To be included
in the category, a fund must consistently have
a beta to equities of between 0.3 and 0.8
(for categorization purposes, in the United States
the S&P 500 is typically used as the benchmark)
and gross short exposure of at least 20%.
Given their high relative volatility and net long
exposure to equities, these funds tend to be
considered as a substitute for other growth assets,
like long-only equities.

Most of the funds that fall into the lower right
corner of the alternatives style box are classified
in the managed-futures category. Other
strategies, like Hussman Strategic Growth HSGFX,
which has been net short equities via written
options because the manager thinks the
stock market's valuation is unsustainable, can also
end up in this corner of the style box. Here's the
category breakdown:

Morningstar analysts recommend only one
fund that falls in the high-correlation, highvolatility region of the alternatives style box as of
July 31: Bronze-rated Diamond Hill Long-Short
DIAMX benchmarks itself to a custom 60%
Russell 1000/40% cash index, but its net exposure
can vary above or below 60% depending on
management's view. That's typical of the other
funds in the long-short equity category and
those that fall in the same region of the
alternatives style box. Here is the breakdown of
funds by Morningstar category as of July:

Managed Futures

Multialternative

Option Writing

Multicurrency

Long-Short Credit

Investors should treat the due diligence of
long-short equity funds as they would any active
equity manager. The fund's returns are going
to be driven by management's ability to identify
stocks that are both undervalued and
overvalued. Some long-short equity funds do add
an element of market timing by varying net

Alternative Funds With Negative Correlation
and High Relative Volatility
The opposite corner of the style box is composed
of alternative funds that have exhibited a lower
(in this case negative) correlation to global equities
and higher (at least two thirds that of the
index) volatility over the trailing three-year period.
Although the style box's rightmost border ends
at a relative volatility of 1-where a fund's
volatility is equal to that of global equity markets-
in practice some managed futures, multialternative,
and long-short equity funds can be more volatile
than global equities over a three-year period.
(We plot those funds on the style box's border.)

Long-short equity strategies boast several
potential benefits that can recommend them. For
example, adding a long-short equity strategy
to a diversified portfolio can lower overall portfolio
volatility without sacrificing a significant portion
of the equity market's upside. In addition,
short-selling can give managers an opportunity to
add excess returns in ways a long-only fund can't.

Long-Short Equity

exposure levels depending on the manager's
view of the broader equity market. These
more tactical equity managers can be more easily
identified by how their alternatives style box
position changes over time.

Multicurrency

Market Neutral

Long-Short Equity

Option Writing

While having a low or negative correlation to
stocks may seem like a desirable characteristic
in an alternative fund, because it shows the fund
is being driven by different risk factors than
equities, it's important that investors understand
why a fund has acted like it has. Managed-futures
funds look to profit from trends across multiple
asset classes. To follow trends, managed-futures
funds use futures contracts. Futures typically
require a small amount of capital to be held as
collateral, so the funds can have higher notional

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