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.
In Table 2, we present those same three funds' returns over a series of market upturns and drawdowns. During the 2000-02 tech bubble burst , JPMorgan Research Market Neutral Income faired quite well (gaining 10.4%). It was also the only fund (of the three) to produce positive returns during the 2007-09 drawdown. So an investment in this fund would have protected a traditional portfolio from losses just when investors needed it most. Its more recent performance is disappointing, however. It has failed to recover the small losses incurred during the 2011 stock market drawdown. This fund seems to present a good long-term diversification option, but its longer-term return prospects may be more muted.
Merger MERFX, on the other hand, appears to be much more correlated to the stock market. It fell during every market downturn and gained during every market upturn. This is because, in good times, merger deals are abundant and tend to close, whereas in bad times, deals are scarce and fall apart. Although the fund's correlation appears to be higher than the JP Morgan offering, the fund fell less than 5% during each downturn--a substantial feat. More importantly, though, the fund has also performed well during upturns, handsomely beating the category each time. Therefore, Merger may offer better long-term return prospects than its peers, as long as investors can deal with small losses during times of distress.
Calamos Market Neutral's return profile spells a tale of higher market exposure. The fund fell more than any other market-neutral mutual fund (there were 13 at in existence at the time) and it also gained more than almost every market-neutral fund (33.6%) during the 2009-11 upturn. Indeed, the fund exhibits a beta of 0.33 (over the last three years), which is on the high end for market-neutral funds. The higher risk exposure is due to its half convertible-bond, half covered-call strategy. Convertible bonds are illiquid and can cause significant losses during a liquidity crisis, such as the one experienced in 2008, and the covered-call strategy is basically a muted version of a long-only stock strategy. So while this fund's longer-term returns look good, it may not present the best diversification solution.
Rearview-Looking, but Still a Decent Guide
Even though past returns by definition are historical, they still prove a decent guide for understanding how alternative funds could fare over different market environments. Just make sure to look at returns over market cycles rather than calendar-year periods.