Morningstar Advisor - December/January 2010 - 34

Spotlight Alternatives Catch On In 1997, the SEC allowed mutual funds to short. Investors have been pouring money into alternative investments ever since. Alternative Mutual Fund Flows $8B 7B 6B 5B 4B 3B 2B 1B 0 –1B –2B –3B 98 99 00 01 02 03 04 05 06 07 08 09 U.S. Long-Short Currency Bear Market A more-risk-averse investor, one who values downside protection first and foremost, should allocate toward a market-neutral or arbitrage fund. These strategies will have more correlation to fixed income than to equities, but a good manager should produce returns superior to fixed-income investments. A long-term investor who is interested in alternatives simply for diversification should consider a fund that takes long and short positions in futures such as commodities and currencies. These strategies, which are sometimes called managed futures in the hedge fund world, produce negative correlation to traditional portfolios, so they can perform well when stocks and bonds don’t, as was the case in 2008. The downside is that managedfutures strategies might produce some losses or very small gains when stocks and bonds outperform, as they have in 2009. Over the long haul, however, these investments should produce a positive risk-adjusted return, with a low or negative correlation. The table on the next page presents some examples of how adding an alternative investment would have helped the typical 60/40 stock/bond portfolio incepted Oct. 1, 2003. (The date was chosen to incorporate a full market cycle.) The portfolio holds iShares S&P 500 IVV and iShares Barclay Aggregate AGG. Twenty percent of the portfolio’s equity position was replaced with an alternatives strategy. The representative alternative investments are Hussman Strategic Growth HSGFX for a hedged-equity option, JP Morgan Market Neutral Institutional JPMNX for a market-neutral offering, and Rydex/SGI Managed Futures Strategy RYMTX for a futures-trading fund. (The Rydex fund trades both commodity and financial futures.) The portfolio was rebalanced quarterly. As you can see, an allocation to one of these strategies improved the returns, as well as the Sortino ratios (a measure of downside risk-adjusted return), of a 60/40 portfolio over the past one-, three-, and six-year periods. Alternative ETF Flows Commodoties $40B 35B 30B 25B 20B 15B 10B 5B 0 –5B 04 05 06 07 08 09 Alternative Strategy How to Invest in an Alternative The first thing to ask when considering an alternative investment is this: What purpose will it serve in a portfolio? A less-risk-averse investor who wants exposure to the equity markets but is looking for some downside protection, for example, should allocate part of the equity exposure in his portfolio to a hedged-equity fund. These strategies tend to have higher correlations to the equity market than do other alternative strategies. 34 Morningstar Advisor December/January 2010

Morningstar Advisor - December/January 2010

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2010