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By Jason Stipp | 03-20-2012 10:00 AM

Three Alternatives for Fixed-Income Investors

Morningstar analyst Mallory Horejs says the current environment is right for investors to consider devoting a small slice of their bond portfolios to alternatives such as these three funds.

Jason Stipp: I'm Jason Stipp for Morningstar. It's Diversifiers & Alternatives Week on Morningstar.com, and today we're talking about diversifying that all-important bond portion of investors' portfolios.

Joining me is Morningstar's Mallory Horejs. She is going to talk a little bit about the role that alternatives can play in diversifying your fixed-income exposure.

Thanks for joining me, Mallory.

Horejs: Hi, Jason. Thanks for having me.

Stipp: So, we have talked a lot on Morningstar.com about fixed income and some of the clouds that are on the horizon for fixed income: very low yields right now, but the chance potentially for some higher rates in the future, which could be bad news for bonds.

When you're looking at a fixed-income portfolio, just broadly, why might you want to consider an alternative right now?

Horejs: Well, first and foremost, we see a lot of investors are just over-allocated to fixed income right now. If you look at the flows over the past few years, you see they allocated over $360 billion in 2009, poured in $230 billion in 2010, and just over $120 billion last year. By comparison they've pulled money out of stock funds in each of the past five years. So, while that trend of massive inflows might be subsiding a bit, it's clear investors have very bond-heavy portfolios.

Stipp: We also know that the Fed has come out and said they're going to keep interest rates pretty low for a while, which I think maybe would give some solace to fixed-income investors, but should they be placing so much faith in the fact that rates might stay lower for an extended period of time?

Horejs: I think it's better to diversify this part of the portfolio. There has been a lot of talk over the past few months that they are not going to be able to keep rates low for that long. So, it would be a good idea to consider interest rate risk right now.

And in addition, over-allocation also implies increased credit risk, and over the past few years, we've seen increased correlation between credit risk and equity risk. So, investors that are expecting their bond portfolios to provide shelter during downturns are likely to be sorely disappointed.

Stipp: So if investors are looking to diversify that piece, there are a few alternative categories that they might look to. Can you highlight some of those areas of the alternative space that they might want to start paying attention to at this time?

Horejs: First, they might want to consider a market neutral fund. These funds typically have a lower risk-return profile. It's very uncorrelated to bonds. They manage to generate small, but steady, gains across most market environments. So, they are typically good stabilizers in terms of market downturns.

Secondly, they might want to consider a currency fund. These funds seek to hedge the inflation risk in a bond fund.

There is also non-traditional bond funds; that's a relatively new category for Morningstar. We just launched it last October, but its flows last year were enormous. They pulled in more money than any of the other alternative strategies tracked by Morningstar.

Then, fourth would be a managed futures fund. These funds seek to trade momentum. They look for price trends across different futures contracts, and they typically have a higher risk-return profile than some of the other alternative strategies we look at, but they also are very uncorrelated to stocks and bonds, so they also make great diversifiers.

Stipp: As a portfolio strategy, do you find that investors are doing away with fixed income entirely and going all the way to alternatives, or are a lot of them carving out a portion of their fixed-income portfolios, and maybe taking 5% to 10% and putting it into these alternatives?

Horejs: I'd say more of the latter of those. We really see still strong flows into fixed income, and we see a lot of questions everyday on how to use these funds, how best to allocate, and so typically it's just pulling a small sleeve, maybe using a non-traditional bond fund that's hedging credit risk or duration risk to some extent, rather than just moving all your money.

Stipp: And you folks are doing some research on individual securities, so I've asked you today to bring in a few of the funds that are on your shortlist that investors might want to take a look at. Can you kick it off for us, and tell us the first fund in the alternative space?

Horejs: In the market neutral category, we really like the AQR Diversified Arbitrage Fund. It's run by two academics--Todd Pulvino and Mark Mitchell--and it tactically invests in merger arbitrage, convertible arbitrage, other event-driven strategies, so it's very diversified, and because of that, its maximum drawdown since its inception in 2009 is just 2%. So it makes a great stabilizer. In addition its 3-year Sharpe ratio has outpaced all other funds in the category, so a very strong risk/return profile.

Looking at the currency category, we'd recommend the Merk Hard Currency Fund. It's also had a very good track record. Its annual returns have ranked in the category's top quintile in five of the past six years, and it's also a great risk-return profile.

Then looking at the managed futures category, which is relatively young, but still has some great funds in it, we like the Natixis Managed Futures Fund. It uses adaptive models. So, unlike some other funds in the category, they are changing their approach, they are dynamically allocating across different futures contracts depending on what has worked in the past few months or past few weeks. And so in addition to strong returns, it managed to post a small gain in 2011, whereas most managed future strategies lost money. It's also one of the cheaper alternatives, which is really important when you're picking funds--costs are a big factor--and funds in this relatively young category are very expensive. So, at 1.7% it's not cheap, but it's definitely a cost-effective option.

Stipp: Then the non-traditional bond category, that's a newer category--what are you looking at there? Those funds have a lot of latitude. So, it seems like it's very important to have careful manager selection. Are you folks comfortable yet with any of those funds to recommend any of them at this point?

Horejs: Not at this point. We're still looking at the category. Although the category just launched in October 2009, some of the funds have been around for a while, but they are new to our coverage area. So, we're going to wait for a while to recommend some.

Stipp: All right, Mallory. Thanks for the investment ideas, and for your broad insights on alternatives in the fixed-income space.

Horejs: Absolutely. Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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