Morningstar - Q2 2023 - 42

Strategies
risk? Are they offered at reasonable fee
levels? Do high-net-worth individuals have too
much of them?
To determine the effectiveness of liquid alts as
portfolio diversifiers, it would be helpful to
study detailed performance data, but I don't have
the period-to-period data that would make
such a study useful. EXHIBIT 1 provides summary
data from June 1, 2011, to May 31, 2021.
Rekenthaler summarized:
" During the 2010s, liquid-alternatives funds
averaged an annualized gain of 1.66%,
which placed them behind every fund category
save for a few specialty groups, such
as energy, precious metals, and Latin American
stock funds, and three flavors of short-term
bond funds. "
Liquid alts are designed to be, and marketed
as, uncorrelated investments with little net
exposure to broad stock or bond market moves.
Finance theory tells us that the benchmark
for such an investment is the riskless (U.S. Treasury
bill) rate, which was 0.55% per year over that
period.6
Thus, liquid alts, as a group, beat
the riskless rate by just over 1 percentage point
per year while taking considerable (although not
extraordinary) risk.
An asset that is highly correlated with
equities has risk in that it does not diversify
away from the investor's equity exposure,
which is (and should be) the reason investors seek
out alternatives. Only the equity-market-neutral
and systematic-trend categories had the
low correlations with equities that denote an
effective diversifier. Those two categories
also had the lowest returns. The alts managers
did not prove to be very skilled at generating
returns that were unrelated to the large
rise in the equity markets over the period
shown in EXHIBIT 1 .
Of course, past performance over a particular
10-year period is not a forecast. But the results
suggest that the managers relied on some
amount of equity or equitylike exposure to make
money in this period.
Are Fund Fees Reasonable?
Mutual fund returns are reported net of fees.
I'll analyze fees in some detail in a moment.
For now, though, let's just use the average
expense ratio (which includes fees) of
the liquid-alts funds in Morningstar's database,
which was 1.66% (that was Rekenthaler's
estimate; mine, covering a longer period, is
a little lower). We just saw that, coincidentally,
this was the after-fee performance of the
funds as a group. Thus, the funds were able to
extract 3.32% per year from the market,
of which fund shareholders got half. Rekenthaler
asked sarcastically: " For each dollar that
shareholders have earned, the fund company
collects a dollar for itself. A 50/50 split.
What could be fairer? "
The subtitle of Rekenthaler's article, " a fundindustry
flop, " is apt.
Liquid-Alts Performance When Bond
Markets Declined
To ascertain the diversification potential
of liquid alts, we'd need to know how well they
performed in down markets. Without
detailed return data, we can't tell. But Morningstar
again gives a clue, showing in EXHIBIT 2
the returns on several of its alts indexes in
periods of rising interest rates (that is, falling
bond markets).
EXHIBIT 2
Returns on Select Morningstar Liquid-Alternatives Indexes in Periods of
Rising Rates
Taper
Tantrum
05/01/2013-
08/31/2013
Morningstar US Fund Equity Market Neutral
Morningstar US Fund Event Driven
Morningstar US Fund Relative Value Arbitrage
Morningstar US Fund Options Trading
Morningstar US Fund Multistrategy
Morningstar Global Core Bond GR Hedged USD
Source: Morningstar 2021 Global Alternatives Landscape report.
1.2
-0.2
-1.3
-2.8
Eurozone
Stress
04/01/2015-
06/30/2015
-0.3
-0.2
0.1
0.1
-1.2
-2.2
Trump
Election
08/01/2016-
12/31/2016
0.9
1.8
1.8
0.9
0.3
-2.4
Powell Rate
Hike
01/01/2018-
10/31/2018
0.2
1.8
0.9
-1.2
-2.6
-0.2
Postpandemic
Reflation
01/01/2021-
03/31/2021
2.9
2.7
1.4
2.9
2.8
-2.5
The liquid alts in EXHIBIT 2 were miserable
diversifiers against long-term interest-rate (bond)
risk, except during the early 2021 episode
that Morningstar calls postpandemic reflation.
During that latter period, liquid alts performed
admirably, rising 2.5% on average in a
quarter when the Morningstar global bond
index fell by a comparable amount.
The most recent episode of rising rates was
much more dramatic than any of the
episodes shown in EXHIBIT 2 ; in 2022, the
bond index fell 12.6%, its worst year ever, as
rates normalized from historically low
levels. In an article bravely titled, " Alternative
Funds Are Winners in 2022, " Morningstar
reported that " the average alternatives
fund is down 2.74%. " 7
That's better than the
6 Bloomberg Barclays US T-Bills (1-3 Month) Index. Money market funds follow the Treasury bill rate very closely and are the usual vehicle for individual investors to hold riskless assets.
7 Lynch, K. 2022. " Alternative Funds Are Winners in 2022. " Morningstar.com. Dec. 8.
42
Morningstar Q2 2023

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Morningstar - Q2 2023

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