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Putting Morningstar’s New Style Box to Work

Three ways investors can use the alternatives style box as part of their regular due diligence. 

Jason Kephart, 11/10/2016

In October, we introduced the Morningstar Style Box for alternative funds, a new framework for analyzing alternative mutual funds. The October Fund Spy outlined why we think investors need a convenient way to view the diversification characteristics of liquid alternative mutual funds and the methodology behind the alternatives style box. The article can be found here, but to quickly recap: The appeal of alternative funds lies in their ability to provide diversification to a traditional portfolio of stocks and bonds. The funds can achieve that by either having a low correlation to traditional asset classes or offering exposure to traditional asset classes with lower volatility. Investors lack a convenient way to quickly assess those characteristics, however, which is why Morningstar has developed the alternatives style box.

Now that we’ve established the framework, we can move onto the more exciting part: looking at ways investors can use the concept to aid their due diligence process.

Use Case: Finding the Right Alternative for Your Portfolio
Liquid alternative mutual funds tend to fall into one of two broad camps: strategies that take on equity market risk and hedge against the downside, and strategies that are generally uncorrelated to risky assets. Either of those broad strategies could be a way to damp down a portfolio's overall volatility, but investors would probably use each differently.

A strategy that is solely hedging equity market risk, like an options-writing fund or a long-short equity fund, is likely suitable only as a replacement for some portion of the long-only equity part of the portfolio. A strategy with low correlation is more likely to be funded from multiple asset classes in the portfolio. While there can be a lot of dispersion among funds within a Morningstar Category, the average position of each category within the alternatives style box gives a general starting point for selecting whichever alternative strategy type fits a portfolio best. Exhibit 1 shows the alternative categories' average positions in the style box.


  - source: Morningstar Analysts

Funds in the options-writing category, but not all, make long investments in equities and buy put options for protection. In an equity market sell-off, those puts could have a positive return that offsets some of, but not all, of the losses in their long equity positions. Long-short equity funds generally have net long equity exposure of around 50% and short individual securities or ETFs as their hedge. Similar to the puts, these short positions could be positive contributors in an equity sell-off.

On the other end of the spectrum, market-neutral and managed-futures strategies tend to be the least correlated. Market-neutral funds generally make equal long and short bets on equities, which eliminates most equity beta. This should lead to returns that are based more on stock selection, that is, long positions outperforming short positions, than how the overall market is performing. Managed-futures funds follow trends and can go long and short a variety of asset classes. The ability to capture negative momentum in risk assets tends to make managed-futures funds outperformers when equity markets go south.

is an analyst covering alternative strategies on Morningstar’s manager research team.

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