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A Simpler Way to Invest in Alternatives

A look at what's driving the multialternative trend.  

Mallory Horejs, 07/12/2012

One of the most frequent questions asked of Morningstar analysts is how best to invest in alternatives. Investors recognize the value that alternative, uncorrelated strategies can bring to a traditional portfolio, but the allocation process doesn't always follow a clear-cut path. Manager selection in this relatively new space has always been complicated given the relatively short track record of many of these offerings. Strategy allocation has become increasingly challenging as the liquid alternatives landscape continues to widen and proliferate. For investors just getting started, the simplest solution to the allocation conundrum is to invest in a multialternative fund. 

An All-in-One Solution
Multialternative products attempt to provide a one-stop shop for alternatives exposure by tactically allocating to a diversified portfolio of strategies (long-short equity, market neutral, global macro, and so on). Investors still have to decide how much capital to put toward alternatives, but they won't need to spend time selecting the individual strategies and managers. Multialternative funds come in several different forms: fund of funds (mutual funds/ETFs), separately managed accounts, or unified managed accounts. They can be internally managed, externally managed, or both.

Demand for these types of products has spiked in recent years--24 new multialternative funds launched in 2011, more than in any other category (for comparison, 17 long/short equity funds, 13 managed futures, 13 nontraditional bond funds, nine market-neutral funds, and three currency funds came to market last year). Funds in this relatively young category have also consistently received very strong inflows--$3.4 billion in 2010, $4.4 billion in 2011, and $0.9 billion year-to-date through May. From both the number of launches and strong inflows, it's clear this allocation method is resonating well with both fund companies and investors.

Potential Drawbacks
Multialternative funds do come with a few drawbacks that investors must carefully consider. First and foremost, fees charged by these products are typically very high. Just as in a hedge fund of funds, investors are paying a premium for the portfolio manager's allocation expertise, individual manager selection, and additional layers of due diligence. Multialternative offerings Hatteras Alpha Hedged Strategies ALPHX and Van Eck Multi-Manager Alternatives VMAAX, for example, charge 3.99% and 2.84% prospectus net expense ratios, respectively. Such high fees are painful for investors and leave managers with very high hurdle rates. 

Second, some multialternative funds allocate a portion of their assets to traditional long-only equities or commodities, exposures that investors have likely already incorporated into their portfolios. Virtus Alternatives Diversifier PDPAX, for example, invests largely in long-only commodities, real estate, and infrastructure. Given the hefty price tags on most of these multialternative products, it's essential to make sure they are providing truly unique exposures rather than overcharging for something that can be cheaply obtained through a traditional mutual fund or exchange-traded fund. 

Funds Worth Considering
Despite these disadvantages, there are still a handful of good options to be had in the multialternative category. Natixis ASG Diversifying Strategies DSFAX (Bronze), for example, allocates to three alternative strategies: relative value, managed futures, and currency. While the fund's annualized returns have come up short relative to the category, its minimal correlation to equity markets provides valuable diversification potential. Management employs a program to monitor the fund's trailing 12-month correlation to a basket of global equity indexes on a daily basis. Once the expected correlation surpasses management's target of 0.3, the model will direct the fund to sell short a basket of stock index futures to lower the correlation immediately. This rule-based mechanism has led to a correlation of only 0.1 to the S&P 500 Index (using weekly data since inception through July 7), compared with the multialternative category average's hefty 0.9.

Four-star fund ASTON/Lake Partners LASSO Alternatives ALSOX also provides a good option, largely because of the downside protection it has provided. This fund of alternative mutual funds cuts off the stock market's tails by actively managing risk. When daily volatility nears 1%, the fund trims its equity exposure. As a result, monthly losses (through June 2012) have never exceeded management's 4% drawdown limit, and volatility has been less than half that of the S&P 500. This downside protection comes at a cost--the fund charges a steep 2.54% expense ratio (including the fees of its underlying funds), making it one of the category's pricier offerings. 

 Last but not least, for investors fortunate enough to have bought into 4-star fund Absolute Strategies ASFIX (Silver), the going keeps getting better. This multialternative fund's 2.61% return in 2011 ranked in the category's top 5%. The fund's success rests on manager Jay Compson's ability to select talented subadvisors and effectively allocate capital. Compson favors qualitative, bottom-up managers (as opposed to managed futures or quantitative strategies) who have demonstrated discipline, judgment, and an independent thought process. All relationships are intended to be long-term, although asset growth over the past few years has granted Compson access to what he believes are more skilled managers. St. James Investment Company (an opportunistic equity manager) and Longhorn Capital Partners, LP (global long/short equity), for example, were added to the portfolio in early 2011 and contributed significantly to Absolute Strategies' category-topping performance last year. 

Not a Panacea
With the multialternative approach, investors will still need to decide how big their alternatives bucket should be. The size of the sleeve will depend primarily on an investor's risk tolerance (more risk-averse investors should have more alternatives exposure) as well as on the size of the overall portfolio. Investors will also need to decide where to reallocate capital from. Typically, this money should be taken from the most-risky part of the portfolio; for most investors, this means the equity sleeve. However, once the investor decides how much he or she is comfortable putting toward alternatives and where the money can be pulled from, a skilled mulitalternative manager can handle the rest.

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Mallory Horejs is an alternative investments analyst with Morningstar.
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