Morningstar looks at five P's when analyzing a fund manager: people, parent, process, performance, and price. In terms of People, investors should be wary of alternative fund managers with little or no direct experience in the particular strategy they are running. Shorting and hedging require skill sets that are very different from long-only investing. In terms of Parent, alternative fund firms are typically smaller boutiques, with smaller research teams and minimal operational staff (operations are often outsourced). Infrastructure should grow with the fund's assets.
A manager should be able to clearly articulate his or her strategy and investment Process, no matter how sophisticated it is. If an investor cannot understand the strategy or process, he or she will not be able to judge the investment merits of the fund. Investors should also be wary of funds that are overly reliant on one particular manager's time and ability.
Past performance is important in forming risk and return expectations for a particular fund. Unfortunately, many alternative funds have very limited track records. Most alternative managers, however, have run similar strategies in separate account or hedge fund formats, and these track records should be accessible through Morningstar's separate account or hedge fund databases. When looking at the track record of a related strategy, make sure to understand differences that may distort performance, such as using more leverage or less liquid assets.
Although many alternative managers may claim to follow an "absolute return" strategy that cannot be benchmarked, it is important to look under the hood. Very few managers are able to consistently generate positive returns without taking on some sort of market risk, for which there is usually a benchmark. If the benchmark is not as simple as an equity, interest rate, or credit index, investors can use a Morningstar hedge fund index or the alternative category average.
When assessing performance, investors can look at a fund's alpha, beta, and correlation to various indexes over different time periods. When assessing risk, investors should look at a fund's performance over periods of market stress, as well as the maximum drawdown, or worst loss, experience by a fund. When comparing two investments, a risk-adjusted performance measure is key. The Sharpe ratio, the Sortino ratio, and Morningstar Risk-Adjusted Return (which, when ranked against a fund's peers, becomes the Morningstar Rating), are some examples.
Investors should consider the risks of a particular strategy. For example, trend-following managed futures funds do not perform well when markets experience quick reversals (as they did in 2009), and arbitrage strategies do not perform well when trades become crowded (convertible arbitrage in 2005, for example). Long-short or market neutral equity strategies struggle with performance when stocks are highly correlated to each other (2007-2009).
The final P, Price, can be tricky. Alternative strategies in general are priced higher than long-only strategies, as management is more complicated and more costly. There are, however, cheaper options in every category. Although cheaper is usually better over the long term, cheaper is not always best. A fund's costs should be viewed in light of its performance.