Morningstar Magazine - February/March 2018 - 31

as of year-end 2017. The average fees2 for
large-blend and ultrashort fixed-income
funds were 1.02% and 0.52%, respectively, for 2017.
This comparison shows it can be far cheaper
to lower beta using cash. A long-short equity fund
would need to outperform a combined fee
hurdle by approximately 1 percentage point to
justify the greater cost. While we will detail later
which alternative categories we do believe
have the potential to generate alpha, for now it's
important to understand what exactly constitutes
alpha and what might be mistaken as alpha.
Let's move to a slightly more complicated
Morningstar Category: long-short credit funds.
These funds are the fixed-income variant to
long-short equity funds and can go long and short
various bonds. The products have a very low
(nearly zero) duration profile. Being long one bond
and short another with a similar duration
would equate to having no duration. A cursory
analysis may reveal these funds to be lowly
correlated to bonds. And, indeed, they are-sort
of. Their correlation to the Bloomberg Barclays U.S.
Aggregate Bond Index averages around 0.24.
There's a problem with this comparison, however:
It isn't valid. Long-short credit funds take
on little duration risk, and interest-rate movements
explain approximately two thirds of the volatility
in the U.S. aggregate bond index. So, if we
used this index as our benchmark, we would
be led to believe that long-short credit managers
had a high degree of alpha.
In fact, we believe a better comparison would
be against the Bloomberg Barclays U.S. Corporate
High Yield Bond Index, because long-short
credit funds take on a fair amount of credit risk.
Here, the correlation with the index nearly doubles
to 0.48.
As we can see, understanding the inner workings
of a fund is key, because sometimes we might
mistake beta as alpha. In this case, longshort credit funds offer a beta play on credit.3

But even the high-yield index comparison
isn't perfect, because the high-yield index does
have a few years of duration. So, what
are long-short credit funds' closest substitutes or,
more specifically, their next-best options?
Low-duration credit funds such as high-yield
and bank-loan funds would be a great place
to start. Nontraditional bond funds are similar; they
tend to have less duration. But they are more
unconstrained. They can bet on a wide array
of assets, from currencies to sovereign emergingmarkets credits. That diversification shows;
the funds are only 0.12 correlated to the
U.S. aggregate bond index. However, against the
high-yield index, they post a correlation of 0.67.
Alternatives to Alternatives

By using correlations as a guide, and understanding a bit about what's going on
under the hood of funds, we can find many
examples of assets that we'd consider
comparable to alternatives, or next-best options.
Once we realize where the core risks (the
beta exposures) of alternatives truly lie, examples
tend to crop up all over.
While we don't think there are prefect
substitutes lying in plain sight, we do think that
reasonable substitutes abound. As mentioned,
for low-duration, credit-sensitive funds like
long-short credit and nontraditional bond funds,
a low-duration high-yield or bank-loan fund
might fit the bill, as bank loans also offer credit
exposure without duration. Categories such
as option-based strategies conceptionally may be
a bit trickier; strategies such as covered calls
offer both income and equity risk. However, we
find that many of these strategies still have
a beta of around 0.5 to the S&P 500. While there
are no perfect substitutes, it may help to look
at these strategies against the broader backdrop
of other income-producing strategies that bear
equity risks, such as high-dividend stocks,
REITs and master limited partnerships, or possibly
preferred stock.

To identify other next-best options for alternatives,
we look at the betas, correlations, and
return expectations. For example, multialternative
categories are filled with an amalgamation
of various strategies, but they are generally funds
of alternative funds. So, while no single nextbest option is available, it can be helpful
to benchmark this group to a low-risk, low-return
category, such as a conservative multiasset
category. Given the average multialternative fund
provides a 0.25 beta to equities, a category
that has between 15% and 30% equity exposure
isn't a bad comparison in our opinion.
The Value of Low Correlations

To calculate if a lowly correlated alternatives
fund's higher fees are justifiable, we offer a simple,
back-of-the-envelope technique. To make
this work, we need to compare an alts fund to its
next-best options.
The conventional approach would be to add all
these asset classes to an efficient frontier. But an
efficient frontier leaves no leeway for intuition.
If alternatives are even slightly less correlated than
our next-best option, all else equal, the frontier
will cast aside our cheaper, passive option.
Our goal instead is to calculate the low correlation
benefit of alternatives, or essentially the maximum amount an investor should be willing to pay.
For example, we could start by building two
very simple portfolios, both with a 90% allocation
to a 60/40 stock-bond mix (i.e., the stock
allocation would be 54% of portfolio assets, bonds
36%) and 10% allocated to either an alternative
fund or our next-best option. In this example,
we'll use a long-short credit fund and a bank-loan
fund, respectively. To keep everything very simple,
we assume that both the long-short credit
fund and the bank-loan fund will return 3.5% and
have a standard deviation of 3%. (The process
still works if we relax these assumptions.) After
looking at historical data, we conclude the
bank-loan fund will have a 0.55 correlation to the
60/40 allocation versus 0.3 for the alternative

2 Fee data throughout come from Morningstar Direct as of Dec. 31, 2017.
3 Beta here really only tells us half the story. The Greek letter is meant to signify an asset class' sensitivity to the market. So, a beta of 0.5 to high yield can be interpreted to mean that these
funds will gain or lose at half of the rate of high yield. Missing in beta, however, is how strong this relationship truly is, or its R-squared. In this case, that relationship is quite strong, as
average R-squared values clock in at 0.72 for the category, relative to high yield.

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