Morningstar Magazine - February/March 2018 - 30

Spotlight: Alternative Funds

investors are talking about beta again. But
herein lies a problem for alternatives: How do we
go about selecting alts funds when the
line between what is considered alpha and what
is considered beta is so tenuous?
Luckily-or unluckily, depending on your point
of view-evidence reveals alternative funds
to be closer to beta plays than alpha. As far back
as the 1990s, hedge funds were considered
great diversifiers by many because of their low
correlations to traditional asset classes. However,
two important findings changed that belief.
The first was that hedge funds, because of
their less-liquid nature, suffered from revaluation
lags. Their holdings were thinly traded, and
market movements took time to have an impact
on a fund's net asset value.
The second was the discovery that while
many hedge funds offer investors unique
exposures, such as momentum, those exposures
could be copied with passive-and cheaper-
alternative beta strategies. Firms such
as Cliff Asness' AQR Capital Management and
Andrew Lo's AlphaSimplex Group embody
this core alternative beta philosophy, and unlike
hedge funds, their offerings are liquid.
So, many investors learned that there was more
beta in alternatives products than meets the eye.
But then came the 2008 market crash, touching
nearly all asset classes. Many liquid alternatives
mutual funds, back-tests in hand, arrived
on the scene promising low market correlations
and touting the Herculean abilities of their
managers. You couldn't blame investors
for assuming that these funds were alpha plays.
However, once track records were built up,
much like their hedge fund brethren, it became
clear that what liquid alt funds were mostly
dishing out was still beta, albeit in a different form.
It was a classic case of overpromising and
underdelivering, and it came back to bite liquid
alt funds. If funds and their managers hadn't

set such high expectations, then perhaps investors
might have seen performance in a more positive
light. But for a fund company to admit that
its alternatives product was mostly rejiggered beta
would be akin to your coworker boasting
about how average his or her children are. It's just
not something a proud parent would do.
That said, even in this ultra-low-cost passive
world, we think liquid alternatives funds still can
add value-even though we also think that
many of these funds truly are just average. Our
goal is to reset how investors think of alternatives,
so that investors' perception of their performance is more in line with reality and that simpler
comparisons between funds can be made.
For the most part, liquid alternative funds
employ fairly generic beta exposures that can be
broken down into traditional investing building
blocks, such as equity and fixed-income exposure.1
If investors widen their scope and compare
alts to traditional asset classes, they may not need
to bother with alternatives beta; instead, they may
be able to select simple and cheap beta.
Calibrating Our Approach to Alts

We believe the focus-on-beta approach is
highly liberating, but it hinges on first determining
asset allocation. Simply put, this is a matter
of where alternatives allocations are funded from.

Morningstar February/March 2018

Finally, traditional assets can be used to
build best-fit portfolios of stocks and bonds. These
portfolios can be used as benchmarks to
represent a fund's asset-class exposures (beta);
any outperformance, or underperformance,
relative to the benchmark may signify a manager's
skill (alpha). To perform this analysis, we built
simplified factor models that represent an
investor's choice between an alternatives fund and
a custom combination of traditional asset classes.
While we aren't the first to perform this type
of work, our application varies slightly. Instead of
using these models to select individual funds,
we aggerate our data to make a holistic determination on each category-we believe certain
categories simply offer more attractive opportunities than others for investors choosing between
alternatives and traditional funds.
The Bits and Pieces of Alts

Many of the fundamental building blocks
of alternatives funds are traditional asset classes.
Long-short equity funds, which bet both for
and against stocks but generally are only around
50% to 60% of assets net long, are an easy
example because they can be benchmarked
to a simple portfolio of stocks and cash,
with the appropriate mix depending on the
fund's beta.

As we will detail later, a long-short credit
fund, for example, can offer more credit exposure
and much less duration than a traditional
fixed-income fund. Allocating assets to one of
these funds from traditional fixed-income
offerings should be viewed as an asset-allocation
decision. But if the goal is to exchange a
duration allocation for credit, we have a whole
host of available options. Sure, a long-short credit
fund may be one option, but we might
also achieve similar results with a traditional
low-duration high-yield bond fund or a bankloan strategy.

A bitter pill to swallow, however, is that
many long-short funds fail to beat that benchmark
(they don't generate alpha), even before the
massive fee hurdles these managers would have
to overcome to beat a low-cost next-best option.

We refer to these alternatives to alternatives as
"next-best options." Next-best options are not only

The average fee for funds in the Morningstar
Category of long-short equity funds was 1.86%,

1 The free cash flow yields/sales ratio is cash from operations minus capital expenditure divided by sales.

helpful because they can be thought of as
lower-cost substitutes, but like alternatives, they
also can be diversifying. Alternatives can be
great diversifiers, but they don't have a monopoly
on diversification. While imperfect substitutes,
next-best options can help investors consider
low correlations in the appropriate context, and we
can use this concept to quantify if an alternative
fund is worth its added cost.

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