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The Process Pillar

A closer look at the new forward-looking analyst ratings for alternative mutual funds.

Nadia Papagiannis, CFA, 10/24/2012

Morningstar has come a long way since the original Morningstar Rating. Introduced in 1985, the 5-star rating system was designed to quantitatively rank funds on past risk-adjusted performance relative to their peers, on a three-, five-, and 10-year basis. While the Morningstar Ratings are still alive and well, and have shown to be somewhat predictive over time, they paint an incomplete picture for investors attempting to pick the future winners. What happens to a fund if a manager leaves, or if the investment process changes, for example? It's clear that factors other than past performance matter. 

Our forward-looking ratings analyze funds against their peers in five areas, or "pillars": People, Parent, Process, Performance, and Price. Each pillar is rated Negative, Neutral, or Positive. The goal is to find the funds in each category that will outperform relative to their category peers over the next three or more years. We use the same five pillars to rate alternative mutual funds and traditional funds alike, but alternative funds require a unique spin. Here's a deeper dive into our Process pillar. 

Process Is Paramount
A transparent, repeatable process earns big points toward a fund's overall rating. If past performance is not indicative of future results, surely a solid investment process behind the good numbers bodes well for the future. For example, IQ Alpha Hedge Strategy IQHIX follows a transparent rules-based approach to replicating a variety of hedge fund strategies. Hedge fund replication is certainly nothing new, but this four-year-old fund's momentum-based strategy allocation has allowed it to outperform its hedge fund replication peers as well as the multialternative category average since inception.

For less indexlike, more active approaches, the investment process is more difficult to analyze. In general, for fundamental discretionary alternative strategies, we like funds that incorporate a top-down point of view, given how macroeconomic concerns have driven markets during the last five years. For quantitative strategies, we like processes that take into account transaction costs (as many quantitative funds are highly diversified and have high turnover) and processes that use a human element to evaluate the effectiveness of the models.

Regarding both discretionary and quantitative strategies, we focus on how the fund shorts and manages risk. Shorting is more difficult than going long. Timing is critical, because as a short position rides against a manager, the larger the position becomes in the portfolio. Shorting can also be costly. One must pay any dividends or coupons, as well as a fee to borrow for less liquid securities. Wasatch Long/Short FMLSX has a good shorting process relative to its long-short equity peers. Manager Mike Shinnick uses the same fundamental value process to identify possible long and short positions, but short candidates must have a specific catalyst that management believes will cause a near-term price decline. Shinnick also uses technical analysis to time his positions, and he limits each short position to 3% of the portfolio. Diamond Hill Long-Short DIAMX, on the other hand, has a much looser shorting process and has paid the price for it more than once.

In terms of risk management, part of every alternative fund's directive is to control risk. Whereas traditional funds must generally be fully invested and must track a benchmark, part of an alternative fund's value-add is to protect against downside risk. Turner Spectrum TSPEX, for example, a multimanager long-short equity fund, has a lockdown policy that reduces gross equity exposure in the event of a 5% intramonth drawdown. AQR Managed Futures Strategy AQMIX, as another example, targets 10% volatility and reduces risk in five equal steps if the volatility target is breached.

The table lists the 47 alternative mutual funds we have rated, and their respective Process pillar ratings.

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Nadia Papagiannis is an analyst with Morningstar.
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