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A Midyear Review of Alternative Mutual Funds

Alternative strategies are off to a decent start in 2012.

Terry Tian, 07/26/2012

The first half of 2012 was characterized by equity-market euphoria in the first quarter followed by renewed macroeconomic concerns in the second. First-quarter rallies overshadowed second-quarter woes, however, as the S&P 500 TR stock index and the Barclays US Agg Bond TR index rose 9.49% and 2.37%, respectively, in the first six months of the year. Naturally, alternative strategies, which are hedged and are supposed to have lower correlations with stocks and bonds, lagged the market. As a midyear roundup, we examine the out- and underperforming alternative categories and emerging industry trends.

New Launches Continued
The first half of 2012 saw 30 new alternative mutual funds launches, even more than the 25 new offerings in the first half of 2011. Among the 30 debutants, 10 are multialternative funds, suggesting investors' growing need for one-stop alternative solutions. Fund companies continued to roll out managed-futures offerings as well. Eight newly launched managed-futures funds brought the total number of funds in that category to 32. In addition, six long-short equity, three market-neutral, and three nontraditional bond funds joined the alternative mutual fund universe so far this year.

Although product launches surged, inflows into alternative mutual funds slowed from $2.45 billion in the first half of 2011 to $934 million in the first six months of this year. Multialternative and long-short equity mutual funds attracted the largest inflows, bringing in $414 million and $398 million, respectively. Nontraditional bond funds leaked $91 million, the largest outflow among all alternative categories, after two years of substantial inflows.

A Closer Look by Category
Despite the category's outflows, nontraditional bond funds proved to be the best-performing alternative category so far this year. The category average rose 3.22% in the first six months of the year, and only three of the total 40 funds incepted prior to 2012 posted negative returns. Many nontraditional bond funds were aided by a bull market of U.S. corporate high-yield bonds--the Barclays US Corporate High Yield TR index jumped 7.27% in the first half of this year. The category's top performer Scout Unconstrained Bond SUBFX rose 11.05%.

Similarly, long-short equity funds benefited from advances in the broad equity markets and gained 1.53% on average in the first half of 2012. One would expect long-short equity funds to lag the markets in upturns because of their short stock positions. But the performance dispersion seen among the category's constituents was rather unexpected and larger than in other alternative categories. Over the past six months, Royce Opportunity Select ROSFX posted a 16.75% return, the highest return achieved among all alternative funds, while the worst offering, AlphaOne U.S. Equity Long Short AORCX, lost 14.27%.

Multialternative mutual funds fared slightly worse than long-short equity funds, delivering a 1.22% return on average in the first half of the year. Naturally, funds in the category with higher correlation and beta to the stock market fared better. For example, GMG Defensive Beta MPDAX, which has exhibited a 0.97 correlation and 0.84 beta to the S&P 500 index (using weekly data over one year, as of July 21), returned 6.64%, making it one of the top performers in the category. Most multimanager offerings and hedge fund replication strategies, however, fell flat, as nonequity strategies underperformed.

For example, currency funds returned 0.85% in the first half of this year, on average. Several European currencies, such as the euro, the Swiss franc, and the Danish krone, depreciated against the U.S. dollar, which hurt "hard" currency funds (funds that stick to currencies whose central banks are relatively more reliable). Emerging-markets currencies, such as the Turkish lira and Chilean peso, on the other hand, rose against the greenback. The top three currency performers so far in 2012 were all emerging-markets-focused funds--Lord Abbett Emerging Market Currency LDMAX (up 4.78%), PIMCO Emerging Markets Currency PLMAX (up 3.32%), and Ashmore Emerging Markets Local Currency ECYIX (up 3.27%).

Market-neutral funds present more of a mixed picture. The category average eked out a 0.13% gain, but merger arbitrage strategies delivered decent performance (for example, Merger MERFX and AQR Diversified Arbitrage ADAIX returned 1.15% and 1.1%, respectively), while market neutral equity funds floundered. A lower stock market correlation (as evidenced by the CBOE S&P 500 Implied Correlation Index) is typically an ideal environment for equity market-neutral strategies (for example, TFS Market Neutral TFSMX delivered a handsome 3.73% return), but not all funds profited from their shorts. Touchstone Market Neutral Equity TSEAX lost 3.85%.

After experiencing a disappointing 2011, managed-futures funds continued to struggle in the first six months of 2012. The category average posted a 4.01% loss and only three out of the 24 funds (incepted prior to 2012) managed to stay positive because of price-trend reversals. Global equity markets reversed their first-quarter upward trends in April. Commodities, especially energy, experienced similar whipsaws--crude oil dropped sharply during the equity market sell-off in May but bounced back in June, and natural gas ended its extended declining trend and rallied in April. This environment proved to be challenging for most managed-futures mutual fund managers. The bottom performer, Arrow Managed Futures Strategy MFTFX, lost 12.55% in the first six months this year.

Hold on to Your Alternatives
Despite some exceptions, overall, alternative mutual funds are off to a decent start in 2012. Five of the seven category averages stayed positive in the first six months. During a bull run, such as the first half of 2012, investors might lose sight of why they are holding alternatives. But in the long run, it's prudent for investors to have something in their portfolios to smooth out returns.

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Terry Tian is an alternative investments analyst at Morningstar.
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