• / Free eNewsletters & Magazine
  • / My Account
Home>Alternative Investments>Alternatives Investing>ABCs of Alternative Investing

Related Content

  1. Videos
  2. Articles
  1. Are TIPS as Safe as You Think?

    Morningstar's Eric Jacobson offers a formula to gauge whether TIPS are cheap or expensive compared with other assets but also warns of potential risks should long-term yields rise.

  2. How to Make the Most of Your 401(k)

    In this special presentation, get the answers to key questions about the quality of your plan, whether your savings are on track with your goals, how to allocate assets, and what to do with assets when you leave your job.

  3. Investors Grow Cautious on Stocks

    May was the worst month in over a year for flows to U.S. equities, while many core bond funds are receiving inflows as rising-rate concerns abate.

  4. Sharpen Your Portfolio Plan for 2014 and Beyond

    Roundtable Report: At the outset of 2014, Morningstar strategists dig into the market's current valuation and expected return, seek out high-quality U.S. and foreign stock opportunities, size up the role of cash today, assess the Fed's impact on the market, and reveal the best ways to fight inflation.

ABCs of Alternative Investing

Getting back to the basics. 

Mallory Horejs, 08/16/2012

Alpha measures the difference between a fund's returns above its benchmark risk exposure(s) (as measured by beta). A positive alpha figure indicates the fund has performed better than its beta would predict. In contrast, a negative alpha indicates underperformance. When selecting alternative products, investors should look at alpha to measure the value added or subtracted by a fund's manager. Alpha should be considered relative to both standard and alternative benchmarks (such as the Morningstar Long/Short Commodity Index, Morningstar Diversified Futures Index, or the Morningstar MSCI Hedge Fund Indexes.)

Beta measures a fund's sensitivity to market movements. By definition, the beta of a particular market (represented by an index) is 1.00. A beta of 1.10 means that, on average, the fund performed 10% better than its benchmark index in up markets and 10% worse in down markets, assuming all other factors remain constant. Conversely, a beta of 0.85 indicates that the fund gained 15% less than the market during an upturn and lost 15% less during down markets. Certain alternative strategies, such as long/short equity or multialternative, maintain higher equity beta exposure (between 0.30 and 0.80), while most market-neutral funds maintain betas to the S&P 500 Index of between negative 0.3 and 0.3.

Cash collateral can account for 75% of a managed-futures fund's portfolio. Because futures contracts require relatively low initial margins (as low as 5% for 100% exposure, for example), the majority of a managed-futures fund's assets are reserved for collateral. Historically, managed-futures strategies earned decent returns simply by holding Treasuries, but this is no longer the case. In response, some funds have hired outside advisors to invest this cash collateral, taking on credit and duration risks. Some managers take on more risk than others, investing in nonagency mortgage securities, asset-backed securities, 144A restricted securities, master limited partnerships, or even real estate investment trusts. When selecting a managed-futures fund, investors should carefully consider how the cash collateral is managed and if the strategy fits their risk tolerance.

Drawdown refers to an investment's peak-to-trough decline during a specific time period. Investors should analyze a fund's drawdown patterns, particularly its maximum drawdown since inception, to more fully understand its investment risks. Although most liquid alternative products launched after the financial crisis, investors can analyze how these younger funds held up during more recent episodes of volatility (the May 2010 "Flash Crash," or the period from April 26 to July 5, for example) as a proxy.

An expense ratio is the annual operating fee a fund's shareholders must pay. It expresses the percentage of assets deducted each fiscal year for a fund's operating expenses, including 12b-1 fees, management fees, and administrative fees. Transaction fees or brokerage costs, as well as initial or deferred sales charges, are not included in the expense ratio, with the exception of borrowing costs for short positions. Therefore, for alternative funds, its best to look at the net expense ratios, which net out shorting costs. Even after taking into account the cost of shorting, alternative mutual funds tend to have higher expense ratios than long-only strategies for two reasons. First, many alternative products are relatively small (60% of alternative mutual funds manage less than $100 million). Second, these funds often have higher management fees due to their more sophisticated research, trading, and risk management.

Funds of funds specialize in buying shares in other mutual funds rather than individual securities. Most alternative funds of funds reside in the multialternative category, though there are a handful in the other categories as well. There are several advantages to the fund-of-funds approach: namely, convenience, ease of use, and additional layers of due diligence. With a one-stop-shop product, investors no longer need to select managers and strategies themselves. The trade-off is that the expense ratios are very high--sometimes above 3.00%. When analyzing funds of funds, investors must be careful to look at the prospectus expense ratio, rather than the annual report figure, because it includes the acquired fund fees paid to the fund's underlying mutual funds or exchange-traded funds. Investors should also be careful to avoid multimanager products that include allocations to more traditional investments, such as publicly traded REITS or long-only commodity strategies. Investors can gain exposure to these long-only asset classes for a much lower price outside of the funds of funds.

Global Macro funds invest across asset classes (that is, stocks, bonds, currencies and commodities) both long and short based on macroeconomic trends. The approach typically involves a medium-term (several-month) holding period and produces high volatility. Many of the industry's largest hedge fund firms, such as Soros Fund Management and Bridgewater Associates, run global macro strategies. As of May 31, 2012, Morningstar's Global Macro hedge fund category included 236 funds that collectively managed $54.8 billion. Very few mutual funds or ETFs currently employ this strategy.

Hedge funds were the original alternative investment. Alfred Winslow Jones established the first hedge fund in 1949, a private partnership with a 20% incentive fee. Jones' fund was the first to employ an equity market-neutral strategy, and its wild success was documented in a 1966 Fortune magazine article. Following that, these private, illiquid vehicles proliferated, and the term "hedge fund" became synonymous with "alternative." Now, however, most alternative strategies are available to all kinds of investors in public, regulated, liquid structures such as mutual funds (under the Investment Company Act of 1940) and exchange-traded-funds.

Mallory Horejs is an alternative investments analyst with Morningstar.
blog comments powered by Disqus
Upcoming Events
Conferences
Webinars

©2014 Morningstar Advisor. All right reserved.