Morningstar Advisor - December/January 2010 - 33

Market-Neutral Funds Market-neutral funds also buy traditional stocks or bonds, but they aim to hedge out virtually all of the market risk, through the same trading tactics as hedged-equity strategies. Arbitrage funds, such as convertiblearbitrage and merger-arbitrage funds, also belong in this category. These investments are aimed at providing, more than anything else, downside protection, with an upside of a few percentage points greater than the risk-free or U.S. Treasury rate. Commodities Missing Diversification Many investments that people use as alternatives, such as emerging markets, REITs, commodities, and 130/30 strategies, have high correlations with traditional portfolios. To 60/40 Stock/Bond Portfolio Range of 52-Week Correlation To 70/30 Stock/Bond Portfolio Range of 52-Week Correlation To 80/20 Stock/Bond Portfolio Range of 52-Week Correlation Vanguard Emerging Mkts Stock Idx Vanguard REIT Index Inst Vanguard Precious Metals and Mining Wilshire Large Cap Core 130/30 Instl Vanguard Small Cap Index 0.81 0.74 0.67 0.99 0.93 0.63–0.89 0.43–0.85 0.33–0.81 0.99–0.99 0.87–0.96 0.81 0.75 0.67 0.99 0.94 0.64–0.89 0.41–0.85 0.31–0.81 0.99–0.99 0.86–0.96 0.81 0.74 0.67 0.99 0.94 0.65–0.89 0.40–0.85 0.34–0.81 0.99–0.99 0.89–0.97 Commodity investments must be carefully defined. Morningstar’s analysts do not consider stocks with commodity exposure to be alternative investments. Holding physical commodities, through physical-gold or other precious-metals ETFs, is one way to achieve lower correlations to the stock and bond markets, because the risk and return of these investments is related to the supply-and-demand factors of the physical commodity, as well as inventory storage. But most commodities are only accessible through futures. Several mutual funds and ETFs invest in commodity futures contracts, either directly or indirectly (through total return swaps). Commodity futures contracts converge to expected future spot prices, which can be above or below the current futures contract price, depending on the level of hedging or speculation. Therefore, holding a long commodity futures contract can result in a gain or a loss and can switch between a low or high correlation. In the past year, a long-only commodity futures investment exhibited a much higher correlation to the traditional markets, providing less diversification. A better alternative involves taking both long and short positions in commodity futures. Currencies Weekly correlation from Oct. 5, 2003, to Sept. 9, 2009. Stock/bond portfolios are composed of the iShares S&P 500 Index and the iShares Barclays Aggregate Bond and rebalanced quarterly. Correlation of Wilshire Large Cap Core 130/30 Instl is calculated since its inception on Nov. 27, 2007. Maximizing Losses These “alternative” investments would have made terrible stock and bond losses worse. Maximum Loss (%) Bottom Recovery Length of Recovery (Weeks) 60/40 Stock/Bond Portfolio 70/30 Stock/Bond Portfolio 80/20 Stock/Bond Portfolio Vanguard Emerging Mkts Stock Idx Vanguard REIT Index Inst Vanguard Precious Metals and Mining Wilshire Large Cap Core 130/30 Instl Vanguard Small Cap Index –34.39 –39.98 –45.21 –63.67 –72.61 –74.35 –52.46 –59.03 10/14/2007 10/14/2007 10/14/2007 10/28/2007 2/11/2007 5/18/2008 12/9/2007 7/15/2007 3/7/2009 3/7/2009 3/7/2009 10/25/2008 3/7/2009 11/22/2008 3/7/2009 3/7/2009 73 73 73 52 108 27 65 86 Weekly maximum drawdown between Oct. 5, 2003, to Sept. 26, 2009. Stock/bond portfolios are composed of the iShares S&P 500 Index and the iShares Barclays Aggregate Bond and rebalanced quarterly. Drawdown for Wilshire Large Cap Core 130/30 Instl is calculated since its inception on Nov. 27, 2007. traded through forward contracts, which are over the counter but generally safe and liquid. Currency strategies involve taking relative value positions between currencies (betting that one currency will fall relative to another) or directional long and short positions, betting that a particular currency will rise or fall. It’s important to note that just because an investment claims to follow one of the above alternative, low-correlation strategies doesn’t mean that it will succeed. For example, the U.S. open-end long-short category By the same token, long and short positions in financial futures (such as interest rates) and currencies can also produce different risk/ return profiles. Currencies are also frequently average, which is dominated by funds with hedged-equity strategies, produced a 0.98 correlation to a 60/40 stock/bond portfolio in the 52 weeks ended Sept. 26, 2009. The return of the average fund in the category dropped 25% between July 2007 and March 2009. Many long-short funds failed to adequately hedge their long positions as the market tanked. That said, several long-short funds did cushion losses and provide low correlations throughout the market turbulence. Advisors can add value by recommending such investments. MorningstarAdvisor.com 33

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Morningstar Advisor - December/January 2010

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