Why analyzing market cycles rather than calendar-year returns is better for alternative funds.
In a previous article, we discussed how to choose an alternative fund's benchmark. Because many alterative funds perform differently than the S&P 500, their listed benchmarks, or even their categories, risk-adjusted performance measures can be used to compare funds. But when explaining the risk-return profile of a fund to a client, a calculation such as Sharpe ratio can be lost in translation. Statistics such as a fund's returns relative to the market or the category average over a given calendar year, are more easily understood, because most investors can relate to what went on in the stock market during a given year.
When it comes to alternative funds, calendar-year returns don't show the whole picture. First, a calendar period is extremely arbitrary, even for traditional funds. Observing a fund's behavior over a series of market cycles, meaning the peak of the market (whichever stock or bond market is most relevant to a particular fund) to its trough (and vice versa), can give investors a better idea of when it will exhibit good and bad performance, which will allow for better asset allocation (which requires risk and return inputs), as well as better investor returns (by not getting in and out of the fund at the wrong times). Second, alternative funds by definition are not supposed to act like the market; they're supposed to have low correlations. A low correlation over the long term or a full market cycle doesn't mean the fund is always up when the market is down and vice versa (this is negative correlation).
A picture is always worth a thousand words, so below is a concrete example of why one should use returns over market cycles rather than calendar-year statistics when selecting alternative funds.
In Table 1, we present calendar-year returns for three funds in the market-neutral category. You can see that, looking at the last 11 calendar years, each market-neutral fund has exhibited a fairly different return profile than the market and each other. In 2002, for instance, the S&P 500 fell 22.1% and two of the three funds gained, while JPMorgan Research Market Neutral Income JPMNX lost money. In 2005, Calamos Market Neutral Income CVSIX and JP Morgan Research Market Neutral Income lost ground, despite the fact that the market rose. These funds don't appear to exhibit a discernable return pattern, and part of the problem is that the calendar years don't present the whole picture.