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Home>Research & Insights>Investment Insights>Morningstar Expands Alternative Categories

Morningstar Expands Alternative Categories

New categories guide investors through the complexities of alternative investing.

Mallory Horejs, Alternatives Analyst, 06/03/2011

Ten years ago, the investing world could be easily compartmentalized into stocks, bonds, and cash. Since then, however, hedge funds have transformed the investment landscape with sophisticated trading strategies that simply don't fit into the traditional Morningstar Style Box. Over time, a few of these hedge fund strategies found their way into registered mutual funds, prompting Morningstar to introduce a long-short mutual fund category in 2007. The first of its kind, the category originally served as a broad catch-all for anything "alternative" that sought to hedge risk or generate an absolute return. As the definition of alternative investments has changed over time, though, so has Morningstar's categorization system. In 2009 the currency category was added, and in 2010 the market-neutral category was introduced.

In the past year, both the number and variety of liquid alternatives offerings has expanded at a rapid clip; more than 100 alternative mutual funds and ETFs launched in the past year alone, most of them falling into the long-short category. To keep pace with the burgeoning registered-alternative landscape, Morningstar recently revised its alternatives categorization, dividing the overgrown long-short category into three new groups: managed futures, multialternative, and long-short equity.

Managed Futures
Funds in the new managed futures category take long and short positions primarily in futures contracts (although some trade exchange-traded funds) based on trend-following or price-momentum strategies. Managed-futures funds have quickly gained recognition and assets in the past few years, following the strategy's chart-topping performance in 2008. Morningstar's Global Trend Hedge Fund Index, which tracks managed-futures strategies in hedge fund wrappers, increased approximately 10% in 2008, compared with the S&P 500 index's 37% loss. The strategy profited in 2008 and again in 2010 due to its focus on longer-term momentum investing, but fell short in 2009 when the markets experienced some short-term swings. Nonetheless, a managed-futures fund's ability to zig when other investments zag makes it a good long-term portfolio diversifier.

The strategy's recent success combined with the retail market's demand for true diversification prompted the launch of several registered managed-futures mutual funds. Morningstar's category currently includes 16 funds, most of which launched after 2008, making it one of the smallest and youngest Morningstar categories in terms of fund offerings. The oldest fund in the category, Rydex|SGI Managed Futures Strategy RYMTX, which launched in March 2007, is also the largest of its peers, with about $2.5 billion in assets.

So far in 2011, managed-futures strategies focused on commodities have delivered the best results. Rydex|SGI L/S Commodities Strategy A RYLBX posted the category's strongest one-year return (through April) of 19.60%. Direxion Commodity Trends Strat Inv DXCTX came in a close second with 19.05%. As commodities markets will not always exhibit strong price trends, however, many of the funds in the category are diversified across asset classes.

The second new alternative grouping is the multialternative category, which includes funds that offer investors exposure to several different alternative asset classes and investment tactics. The category currently houses 60 distinct multialternative funds, making it the second-largest alternative category after long-short equity, which now contains 73 funds. Overall, funds in the multialternative category are considerably older than those in managed futures; only one fifth of the multialternative category's constituents were launched in the previous year, and the category's oldest fund dates back to 2000.

One advantage of multialternative funds is that they can be used as one-stop shop alternatives allocations. Still stinging from 2008, investors are anxiously seeking ways to better protect their portfolios from downside risk. However, the staggering array of options has left many feeling overwhelmed. These diversified, multistrategy funds help to simplify things.PAGEBREAK

Within the multialternative category, Direxion Spectrum Select Alternative SVC SFHYX has posted the best three-year return (11.1%), earning it a 5-star Morningstar Rating for funds in that time. Absolute Strategies I ASFIX has earned the same 5-star three-year rating, but has delivered only 2.5% in the past three years. Investors should be aware that funds in this category take on varying levels of stock market exposure and therefore will provide varying levels of diversification.

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