Morningstar Magazine - February/March 2018 - 7

Letter From the Editor

Alternatives Through the Years

Jerry Kerns

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@jerrykerns

This is the third time that the magazine has
devoted its Spotlight section to alternative funds,
and it's interesting to see how our view
has evolved through the years. In the December/
January 2010 issue, featuring articles written
in late 2009, we were very supportive of financial
advisors finding a role for alternatives in clients'
portfolios. "As we've shown, alternatives
can do a much better job of diversification than the
typical stock/bond mix." For proof, we replaced
20% of a classic 60/40 portfolio with various
alternative funds and back-tested the portfolios to
Oct. 1, 2003. The alternative allocation-surprise,
surprise-significantly improved performance.
In the same issue, we reported the results of a
Morningstar survey on advisors' use of alternatives.
Fifty-eight percent of respondents predicted that
alternatives would become as important or
more important than traditional investments over
the next five years. Nearly half said that they had
"most of their clients in alternatives."
Now that the U.S. stock market has about
quadrupled in value since it bottomed
out in March 2009, it's easy to roll one's eyes at
this thinking. But investors had just suffered
huge losses in the financial crisis of 2007-08, after
being told by professionals that their portfolios
were properly diversified. Investors in 2009 were
demanding a new approach to downside
protection. The lure of alternatives was strong.
We next visited alternatives in 2013, with
a more critical eye and a buyer-beware approach.
"Investors have been seduced by the call of
diversification into buying overvalued, cyclical
strategies marketed as alternative investments and
paying high fees to obtain them," we wrote in the
June/July issue. We recommended focusing
on two elements that we said were key to properly
analyzing alternatives: the drivers of return and
valuation. Does an alternative investment behave
differently enough from stocks and bonds
to be a useful diversifier? If it does, is it is worth

buying at current prices? An overvalued asset,
no matter what it is, increases downside risk.
Since then, as we discuss in this issue, we've
developed the Morningstar Style Box for
alternative funds, which recently became available
in Morningstar Direct. In "Mapping Alternatives"
(Page 34), analyst Jason Kephart illustrates
how the style box can help investors better
understand whether and to what extent a strategy
might diversify a portfolio and dampen volatility.
High fees remain a concern-particularly
given that many alternative strategies offer more
beta than alpha, as analyst Josh Charney
argues in "A New Way to Approach Alternative
Funds" (Page 29). Traditional strategies may offer
similar beta exposures more cheaply. Why pay
more for a long-short credit fund when a
bank-loan fund offers nearly the same desired
diversification properties? Charney explores when
such "next-best options" may be better choices
than an expensive alternative.
As our coverage of alternatives has progressed
over the years, one thing has become clear:
It pays to do a deep analysis of these investments
and understand what they truly do.
Note

This issue includes the final installment of Carl
Richards' Behavior Gap column (Page 20) and the
debut of Stephen Wendel's Behavioral Insights
(Page 18). During his eight-year run with the
magazine, Richards and his sketches have taught
advisors how to help clients make better
financial decisions. Wendel, Morningstar's head
of behavioral science, will pick up that theme.
In this issue, he calls on the financial-services
industry to measure success by the actual impact
of its products and advice on clients.

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