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Breaking Down the Multialternative Category

We wrap our arms around this fast-growing category.

Josh Charlson, 03/31/2016

The U.S. multialternative Morningstar Category has been the fastest-growing alternative category during the past few years, and arguably the site of many of the most interesting innovations in the industry. In 2015, the multialternative category saw some of the strongest net flows of any category, alternative or otherwise, bringing in $17.6 billion in net new investor dollars. From a mere 25 distinct funds and $6.3 billion in assets in 2007, the category has expanded to 157 funds and more than $55 billion as of year-end 2015. The category may be on a tear, but its constituents are heterogeneous, both in terms of investment strategy and quality. In fact, only nine funds that receive Morningstar Analyst Ratings are Medalists, a signal that Morningstar analysts think the fund will outperform its peers or benchmark during a full market cycle. In general, we have doubts that many of these funds can rise above their significant fee hurdles.

Morningstar defines a multialternative fund as one that encompasses multiple underlying alternative strategies. At least 50% of the portfolio should consist of those alternative strategies, and in general the fund should exhibit other characteristics investors expect from alternatives funds, such as fairly consistent gross short exposure of 20% or more and/or low beta and less correlation to traditional asset classes.

To help investors make better sense of the category, we have identified three main substrategies within the multialternative category: multistrategy, global macro, and hedge fund replication. These substrategies are nuanced and have evolved as the category has grown, so Morningstar does not specifically identify them as such in our database. Instead, analysts currently identify funds in each substrategy qualitatively. This article includes a few of the telltale markers investors can use to identify these substrategies, as well as a table with the 20 largest multialternative funds and their substrategy designation.

Roles in Portfolio
Within the category, multistrategy and hedge fund replication funds probably provide the best fit for investors seeking diversified, hedge fund-like exposure, because the funds reliably provide exposure to a range of underlying hedge fund strategies or factors; they can serve as core alternative allocations. Global macro funds can also serve this purpose, particularly those that are very risk-controlled, but global macro funds are far more dynamic in their allocations and thus less predictable, and at times they may take on big bets or ramp up equity exposure. Thus, they may be better suited to a satellite or more aggressive alternative allocation.

Multistrategy
The multistrategy approach is by far the most common in the category, representing about two thirds of the category. Multistrategy funds allocate to distinct alternative strategy sleeves in the portfolio, using a variety of techniques and structures. Although portfolio managers may alter their allocations to the sleeves over time, the allocations are generally fairly static or strategic in nature. Within the multistrategy bucket, there are several distinct subtypes.

Multistrategy: Fund of Hedge Fund Managers
These funds have taken advantage of the increasing numbers of hedge fund managers willing to offer versions of their strategies to mutual funds for a straight management fee, with no performance fee. We count roughly 40 funds that follow this approach. Typically, the mutual funds are structured through managed accounts, where the hedge fund managers' trades are disclosed to the advisor each day. One of the advantages of this structure is the access mutual fund holders get to hedge fund managers typically unavailable to individual investors. A downside comes from the higher management fee demanded by the subadvisors, making these investments far more expensive than the typical mutual fund or even than the average alternative mutual fund. Moreover, it can be difficult for investors to track the allocation to each underlying hedge fund strategy and the resulting performance attribution because all securities are pooled together in the portfolio. Thus far, we have found that these types of strategies have rarely overcome their higher fees, and Bronze-rated Litman Gregory Masters Alternative StrategiesMASFX currently stands as our sole recommended fund of hedge fund managers (and Litman Gregory tends to use subadvisors who are better known for their mutual fund offerings, such as First Pacific Advisors and Loomis Sayles).

Multistrategy: Fund of Mutual Funds
There are also around 40 multistrategy funds that employ a traditional funds-of-funds structure. In these vehicles, the managers allocate to other 1940-Act Mutual funds to achieve the overall objectives of the fund. These funds often incorporate an additional layer of fees, but on balance their all-in fees have been lower than those using hedge fund managers in separate accounts. Thus, two of the key benefits of this approach are lower relative fees and greater transparency, as investors can observe the discrete performance of the underlying funds. A drawback is that it may be harder to find truly differentiated strategies or those that rely on less-liquid securities in a mutual fund; moreover, some funds using this design have leaned on more traditional strategies and asset classes, such as concentrated equity or core-plus bond strategies, for at least part of their allocation. A fund we like in this subgroup is Bronze-rated John Hancock Alternative Asset Allocation JAAAX, run by a team with deep experience in manager selection and asset allocation, from a firm that was an early adopter of alternatives in mutual fund format.

Multistrategy: Single Manager
Single-manager multistrategy funds rely on the internal expertise of the asset manager to allocate across teams or strategy types within the firm. There are significantly fewer funds pursuing this approach (around 15), as few firms, including AQR and Natixis, possess the breadth of expertise across multiple alternative strategies required to successfully execute it. Further benefits of the single-manager design are lower fees--as there are no additional layers of fees and management is typically leveraging common resources--and a more seamless coordination between the underlying strategies. The Medalist strategy in this subgroup is represented by AQR Style Premia Alternative QSPIX and AQR Style Premia Alternative LV QSLIX, which rely on AQR's long history of research in factor analysis and quantitative research.

Josh Charlson is a senior fund analyst with Morningstar.

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