Morningstar Magazine - February/March 2018 - 11

The Alternative
Time Warp
These innovative
strategies are actually
behind the times.
PHILLIPS CURVE

Second, guidance on how to deploy alternatives
must improve. Too many ill-defined activities
occur under the alternatives banner. As such, it's
very difficult for investors or their advisors
to set appropriate expectations for the alternatives
they consider. It's not dissimilar to the fund world
of 30 years ago where you had to be an inside
player to know that Vanguard Windsor VWNDX
was a value fund and Janus a growth fund,
that Templeton Growth TEPLX scoured the globe
for investments, but Fidelity Magellan FMAGX,
despite its globe-spanning name, focused just on
the United States.

Don Phillips

The gravitational forces that drive the rest of
the mutual fund market-toward lower fees, more
transparency, and better investor outcomes-
seem not to apply to the alternatives part of the
fund world. Despite much innovation and the
emergence of credible new players, the alternatives space looks more like the fund world of
yore than the investor-focused fund world of today.
In short, while the fund market as a whole has
become a place driven by the demands of buyers,
the alternatives space remains a seller's market.
Four things must change to turn the odds more
in investors' favor and make alternatives a
part of the mainstream fund world. First, fees must
come down. The reality distortion field that has
allowed alternative investors to charge higher fees
despite their lower returns simply cannot last.
How much longer will advisors who purge
traditional active managers for the cost savings of
index funds tolerate the inflated fees of alternatives, especially as the disappointing returns of
many of these funds continue to accrue? The same
math applies to all investments. If high fees
undermine the attractiveness of active managers,
higher fees must do even more to undermine
the allure of alternative managers. The expectations of miraculous performances will diminish
as disappointing investor experiences accumulate.
Low costs cannot remain a factor that is worshiped in most of the portfolio, but ignored
in another part. Vanguard's continued experimentation with alternatives (one imagines to
Jack Bogle's horror) may prove a catalyst for this
inevitable change.

Today, many investors buy alternatives as a
form of insurance against a market correction
without realizing that many alternatives are highly
correlated with the market. It's like buying
insurance but not knowing if you're insuring your
house, your life, or your car. Such misalignments
must be addressed if investors are to use
these funds successfully. The new Morningstar
Style Box for alternative funds may make
a contribution toward better deployment of
alternative funds. Fund companies can also help
by setting clearer expectations for their funds
and by demonstrating how these funds can
be properly deployed in their own fund-of-funds
offerings like target-date funds. Until alternative funds are deployed better, they will do more
to damage the industry's reputation than
to enhance it.
Third, trusted traditional players must join the
party. Innovation always starts from the edges, and
each major innovation provides an opportunity
for new players to rise. Yet ultimately, the
established players must follow suit if the trend
is to go mainstream. T. Rowe Price may have been
a small-cap pioneer, but it was older firms
following suit that made small-cap a part of the
investor tool kit. The same was true for Templeton's forays into international stocks. While
innovators spur change, it is the competition from
established players that marks the maturation
of the trend. To date, investors have benefited from
quality firms such as AQR entering the business
and opening up new channels in the alternatives
space, but it is the endorsement of firms such
as Vanguard and Fidelity that will stamp alternatives as part of the investment mainstream.

Finally-and most importantly-alternatives
must generate real-world success stories
that advisors and investors can point to in order to
justify their faith in the category. To date, these
have been few and far between. Investors ignored
alternative strategies before the financial
crisis of 2007-08, but then flocked to them in its
aftermath, buying what they wish they had bought
two years earlier. Over the ensuing decade,
those enthusiasts have seen paltry returns from
their alternative choices relative to the outsized
gains won in broad market indexes and in
traditional active funds. Therein lies the core
difficulty of alternatives. In bull markets, investors
focus on relative returns. It is only after losses
that their attention shifts to absolute performance.
If an investment attracts money when it is entering
a period of relative underperformance, but
loses that money before it can generate superior
absolute returns, it does investors no favors.
Ultimately, it is the investor experiences
that are generated that determine the true success
of an investment. To date, index funds have
created good investor outcomes; alternatives have
not. Hence, indexing has gained greater
general acceptance. Figuring out how to generate
better investor outcomes is the key to the
eventual adoption of alternatives into the investor
tool kit.
It remains to be seen whether alternatives
will earn investor loyalty or if the category will be
another in a long string of black eyes for the
financial-services industry. The potential to better
investor outcomes seems to be there. Indeed,
the interest expressed in the category by credible
players such as Vanguard and PIMCO plus the
credibility of new players such as AQR and
Research Affiliates bodes well for the possibilities
of the category. To date, however, the alternatives market still looks too much like the flawed
mutual fund marketplace of the 1980s, a time
when funds were sold and not bought, than
it resembles today's modern, investor-centric fund
world. Time will tell if alternatives can break out
of this time warp and make a credible contribution
to investors' success and the industry's future. K
Don Phillips is a managing director with Morningstar. He is
a member of the editorial board of Morningstar magazine.

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