The Performance Pillar

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 Performance pillar.

Performance
In the end, performance is what matters. And whether a fund follows a traditional or alternative strategy, performance is relative: relative to peers, relative to market exposure, or relative to the cheapest substitute (a similar exchange-traded fund, for example). There are different ways of slicing and dicing performance as well; just looking at total return does not give an investor a clear idea of a fund's risk and return profile. That's why we created the Morningstar Rating. It measures how a fund ranks relative to its category peers in terms of risk-adjusted return. It's similar to the Sharpe ratio, but it takes into account a fund's tail risks as well.

Unfortunately, the Morningstar Rating can only be calculated using a minimum of 36 months of returns, which means that many alternative funds are not rated. Morningstar calculates several metrics beside the Morningstar Rating, though, to help investors assess its historical risk and return. Alpha is probably the most important, as alpha measures an active manager's skill, and most alternative funds are actively managed. The key to calculating alpha is selecting the best benchmark index. For this, we look at a fund's portfolio holdings as well as the Morningstar Best Fit Index. For example, JP Morgan Strategic Income Opportunities' JSOAX prospectus says, "the Fund has an absolute return orientation, which means that it is not managed to an index." Looking at the portfolio holdings of the fund, however, it's clear that it concentrates on high yield. Morningstar's Best Fit Index for the fund is also a high-yield index (versus the index listed in the prospectus, Barclays US Universal Index).

Of course, strategies like merger arbitrage and managed futures have no widely accepted or widely available benchmark indexes. We would then compare these funds' returns with that of their category average or a smaller subset of peers within the category. Another option is to compare them to our hedge fund category indexes representing the same strategies (the Morningstar MSCI Systematic Trading Index is an index of managed-futures funds, for example), or ETFs/ETNs that follow similar but more-indexed strategies (WisdomTree Managed Futures WDTI, for example). When comparing returns, risk-adjusted measures such as the Sharpe or Sortino ratios are more prudent than total return measures.

Finally, it's important to look at returns in different types of market environments: upside/downside capture ratios, which look at returns when the benchmark index is positive or negative, respectively; Morningstar Bear Correlation, which measures the correlation of a fund to a benchmark in negative months; maximum drawdown, which measures the fund's worst loss over a period of time using monthly returns; and the returns of the fund during periods of stress for a particular strategy (for example, 2011 was a horrendous year for managed-futures funds).

This table lists the 48 alternative mutual funds we have rated and their respective Performance pillar ratings.