What investors can glean from the 40 new alternative Morningstar Analyst Ratings.
Last week, Morningstar launched 40 qualitative ratings on alternative mutual funds. While the jury is still out on a number of key issues surrounding the use of alternative mutual funds--for instance, the allocation question--the launch shines more light on this once relatively obscure space. Investors somewhat acclimated with alternatives will find the ratings quite handy in pinpointing best-of-breed funds. Because Morningstar's alternative categories are extremely granular, these new forward-looking ratings can add substantial value for investors.
When selecting the coverage list, Morningstar primarily focused on assets and relative interest. For instance, although The Collar
Just as our trademark Morningstar Rating for funds, or “star ratings,” are calculated using risk-adjusted performance rankings relative to the category, the analyst ratings are also determined relative to a fund's peer group. However, comparing alternative funds within the same category isn't as cut and dried as, for example, analyzing funds within the large-cap growth category. Long-short equity is arguably the most homogeneous alternative category, but its constituents are by no means similar (the fund's betas range from 1.7 to negative 0.4). Thus, for some of the more unique funds, Morningstar must first determine if an investor would benefit from the fund's unique strategy and then evaluate how its risk-adjusted performance has stood up to the category. Marketfield MFLDX (Bronze), for instance, employs its macro research to determine overall exposure. Its process, though unique, has proved to protect investors in dark times, and it has handsomely beaten its category since inception.
There are also distinct strategy subsets within certain categories that aid in the comparison process. In the multialternative category, for instance, there are three hedge fund replicators--Goldman Sachs Absolute Return Tracker
Why Only One Gold
TFS Market Neutral
Rating a fund Gold implies all its stars are aligned, while a Bronze or a Silver, though still positive, mean there are some areas that could use improvement. Key areas of concern for alternative offerings, for instance, lie with the fund's Price and People. It is no secret that alternative funds are generally more expensive than traditional funds (because they are smaller and have more-complicated strategies). Absolute Strategies
Is Market-Neutral the Best?
The big winner from last week's rating launch, by far, was the market-neutral category. Of the eight market-neutral funds rated, one received Gold, three earned Silvers, and two scored Bronzes. So, is market-neutral the best alternative category? Not necessarily. There are 34 funds in the market-neutral category, and of the eight included in last week's launch, six were pretty good. The other reason six funds were recommended is partially because of the poor performance of the category, which has exhibited negative performance on the whole for the past four years. The funds awarded Silver and above all had either 4 or 5 stars. This metric is slightly diminished once the category's weak performance is accounted for because the star rating is based solely on comparing a fund with its category.
Relative strength aside, the market-neutral category truly exhibits many well-designed and -managed funds. Arbitrage
A Neutral Stance on Non-Traditional-Bond Funds
The non-traditional-bond category is the newest and, thus, least-proven category. Funds in this category hedge interest-rate and/or duration risk and fall primarily into two buckets--unconstrained, go-anywhere strategies and long/short credit offerings. Eaton Vance Multi-Strategy Absolute Return
It's hard to predict exactly where the distribution of alternative ratings will go from here. If lower-quality funds, for example, enter the coverage list, the number of Negatives should increase. On the other hand, smaller alternative fund shops are growing in sophistication and resources. If that trend continues, other funds should join TFS Market Neutral at the top of the class.