New Alternative 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.

Determining Coverage
When selecting the coverage list, Morningstar primarily focused on assets and relative interest. For instance, although The Collar COLLX (Bronze) has only $36 million in assets, it’s the only long-short fund available that collars all its holdings (by buying puts and shorting calls) and selects stocks based solely on option skews. Morningstar also didn't go out of its way to cover bad funds. Of the 40 funds now rated, six were assigned a Negative, 17 were assigned a Neutral, and 17 are Positive medalists (Gold, Silver, or Bronze).

Somewhat Relative
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 GARTX (Negative), Natixis ASG Global Alternatives GAFAX (Neutral), and IQ Alpha Hedge Strategy IQHIX (Bronze). Because hedge replication represents a niche subset within the multialternative category, the three were analyzed within the context of each other. IQ Alpha Hedge Strategy is Morningstar's only positive hedge fund replicator because of what we believe is a superior process of overweighting winning hedge fund strategies. Goldman Sachs Absolute Return Tracker received a Negative because the other two were leaps and bounds ahead in terms of their replication techniques. But it wasn't necessary to give one of the replicators a medal. In terms of the ratings distribution, Morningstar doesn't have a preset number of Negatives or medalists.

Why Only One Gold
TFS Market Neutral TFSMX was the sole Gold-rated fund in the entire alternative fund lunch. This is not to say there aren't plenty of great options--a Bronze, Silver, or Gold all represent a recommended fund. It also doesn't suggest that TFS Market Neutral is the best alternative fund, only that it is the best option within the market-neutral category. The evidence supporting TFS Market Neutral was overwhelmingly strong: Management is a proven steward, it has actively closed the fund when the strategy reached capacity, and the fund exhibits a superb track record (the fund is rated 5 stars).

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 ASFAX (Silver), for instance, lost points for its above-average fees. When evaluating alternative managers, it's very important to see short-selling experience, but this skill may sometimes be lacking. Diamond Hill Long-Short DIAMX (Neutral) applies its long process to its shorts, which can be a recipe for trouble. Indeed, its short positions have hurt the portfolio several times in its history.

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 ARBFX (Silver) and Merger MERFX (Silver) were both awarded a positive, in part, for their strong People and Process scores. Both are leaders in the merger arbitrage space. The category also has some of the oldest and experienced funds in the alternatives space. Calamos Market Neutral Income’s CVSIX (Bronze) inception was in 1990, and the same lead managers have been with the fund since. Another long-standing fund, JPMorgan Research Market Neutral JPMNX (Bronze), had its inception in late 1998. It employs a strong knowledge base of 23 senior analysts. Overall, there are many worthy players in this category.

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 EADDX (Neutral) has delivered above-average returns since its strategy change in July 2009, while other non-traditional-bond funds flopped in 2011 (returning only 0.7%). But the relatively unconstrained nature of many of the category's constituents remains slightly problematic. This fund in particular has the flexibility to invest in a wide range of asset classes and strategies. About half the fund's assets are invested in commercial mortgage-backed securities, and management even allocates a small portion of the portfolio into a rules-based options strategy on the S&P 500. Two non-traditional-bond funds were included in last week's launch; both rated a Neutral as their strategies are somewhat unproven.

Going Forward
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.