Morningstar Magazine - February/March 2018 - 9

EXHIBIT 1

composed of cheap beta exposures to avoid
manager risk, and challenge yourself to a
thought experiment in which equity and bond
markets don't run in one, blissful direction.
Liquid alts may be part of your answer.
Before Answers, More Questions

Unfortunately, alts' challenges are not limited to
running against prevailing best practices.
Invidious Comparisons
One of the biggest challenges for liquid alts
funds is that they are compared to other mutual
funds. This is inevitable because of the legal
wrapper in which they are sold. Fund databases
track open-end funds, and liquid alts are
open-ended. And because they're tracked, they
will be compared against very different funds.
Since 2009, comparisons of alts to vanilla
beta strategies are not flattering. In fact, the same
could be said of comparisons of almost any
actively managed strategy against beta. It has
been nearly impossible to deliver alpha
when the market has moved in only one direction.
But returns don't tell the story at all. Long-short
equity's five-year beta to the S&P 500 was 0.56
( E X H I B I T 1 ), so its risk-adjusted return is something
closer to 10% than 6%.
Today, however, investors are fixated with the
upside and ponder how we overlooked
opportunities to make a 1,000% return on bitcoin
in a year instead of a measly 20% earned
in the stock market. The higher the stock market
flies, the harder it is to hear alts' message.
Fear of the next downturn has transformed into
a fear of missing out. Greed is resurgent. Alts'
mostly sobering message is being drowned out by
a cacophony of optimism and speculation.
One-time alts standard-bearers such as (MainStay)
Marketfield MFLDX in the United States and MS
INVF Diversified Alpha Plus in Europe raised
questions about hard-to-see risks: Shareholders
who flooded in after strong returns flooded out
when performance nosedived.

Alternative Categories Have Lagged on an Absolute Return Basis
3-Year Total
Return (%)
(Annlzd)

5-Year Total
Return (%)
(Annlzd)

10-Year Total
Return (%)
Rating

5-Year
Beta
(S&P 500)

Asset Class

Morningstar Category

U.S. Equity

Large Blend

9.70

14.24

7.61

1.00

International Equity

Foreign Large Blend

7.73

7.27

1.79

0.92

Taxable Bond

Intermediate-Term Bond

2.22

2.05

4.06

-

Short-Term Bond

1.47

1.15

2.31

-

Long-Short Equity

3.93

6.23

4.43

0.56

Managed Futures

0.07

3.26

-1.83

-

Market Neutral

0.87

1.13

0.91

-

Multialternative

1.79

2.65

1.16

-

Multicurrency

0.43

-0.34

-0.10

-

Options-Based

4.59

5.41

3.05

0.45

-19.89

-22.83

-21.48

-

Alternative

Bear Market
Source: Morningstar Direct. Data as of 12/31/2017.

Guilt by Association
Alternatives are not an asset class. They are
a catch-all for a variety of investment strategies.
For attention-challenged investors, it's
tempting to paint all alts with the same brush.
Bad investor experiences in bear-market
funds can unfairly color investors' perceptions
of other strategies in the alts bucket.
Bear-market funds are not even the most troublesome. Leveraged-equity, inverse-leveraged-equity,
and leveraged-commodities ETFs have made
mincemeat of alts' reputations among casual
onlookers. Did you think a max drawdown
of almost 100% over three years was unthinkable?
Direct your gaze to VelocityShares Daily 2x VIX ST
ETN TVIX, and think again.
Bad Timing
Unfortunately, as senior alternatives analyst
Jason Kephart found,1 for those investors who did
take the alts plunge, their timing was lousy, as
measured by Morningstar Investor Return. Kephart
found that investors in managed futures fared

the worst. Over a recent three-year period, nearly
one in five of these funds had investor return
gaps of more than 500 basis points. Half had at
least a 100-basis-point gap, which is significant as
the average managed-futures return was only
1.46%. One fourth of market-neutral fund investors
experienced investor return gaps of more than 200
basis points annually; the average return for these
funds was negative 10 basis points annually.
Bad Optics
Compounding liquid alts' troubles are high
costs. Morningstar's Patty Oey discovered that not
only are fees not falling along with the rest
of the funds, asset-weighted fees are rising.2 This
is puzzling, even for liquid alts. The reason:
Investors have favored proven strategies that have
relatively high expenses over lower-priced,
less-proven strategies.
The asset-weighted average cost of all alts funds
is 1.34%, more than two and a half times
higher than the same figure for U.S. equity funds.
Alts category expenses are nearly double the

1 Kephart, J. 2017. "Look What These Liquid Alts Made Investors Do." Morningstar.com, Sept. 28. http://news.morningstar.com/articlenet/article.aspx?id=827062
2 Oey, P. 2017. "Investors Experience Higher and Rising Fees for Liquid Alternative Funds." Morningstar.com, Nov. 28. http://news.morningstar.com/articlenet/article.aspx?id=838352

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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
Morningstar Magazine - February/March 2018 - 5
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