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A New Framework for Analyzing Alternative Mutual Funds

Introducing the Morningstar Style Box for alternative funds.

Jason Kephart, 10/20/2016

Liquid alternatives are a potentially useful tool for building well-diversified portfolios. These strategies are designed to provide low exposure and low correlation to traditional asset classes, primarily stocks and bonds, which could help smooth out returns and lower maximum drawdowns at the overall portfolio level.

While that's an admirable goal, it's difficult to achieve, and alternative funds have had varied levels of success when it comes to differentiating return streams from traditional asset classes. Achieving such diversification is critical for alternative funds: If they are offering only returns derived from beta (market) exposures, then investors are better off sticking with traditional investments, which will likely be much less expensive.

Yet investors lack a convenient means of quickly assessing these characteristics in a strategy and comparing it with peers. To remedy this state of affairs, we are introducing a new research framework called the Morningstar Style Box for alternative funds (hereafter, the "alternatives style box").

By providing an easy-to-understand visual representation of an alternative fund's diversification and volatility characteristics over time and versus peers, the alternatives style box allows for informed comparisons between funds running similar strategies and other liquid alternatives strategies in a single glance.

Initially, the alternatives style box will be used as a research tool for Morningstar analysts and included in our published research; ultimately, it will be a data point and tool available in Morningstar products.

  - source: Morningstar Analysts

How It Works
The alternatives style box has several key differences when compared with the Morningstar Style Boxes for equity and fixed income. Unlike the equity and fixed-income style boxes, the alternatives style box is not based on portfolio holdings. Portfolio data for alternative strategies is not always available or reliable given their heavy use of derivatives. Instead, alternative strategies are plotted on the style box based on historical performance characteristics, namely, correlation and volatility relative to a market-cap-weighted global equity index.

  - source: Morningstar Analysts

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

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