Jason Stipp: I'm Jason Stipp for Morningstar. This week we're rolling out Morningstar's Guide to Better Investment Picking, and today we're checking in with senior alternatives analyst Josh Charney about better alternatives investment selection.
Josh, thanks for joining me.
Josh Charney: Thank you, Jason.
Stipp: Alternatives is a pretty broad category. Lots of different types of funds might be in alternatives. How does Morningstar look at alternatives? How do we break it down?
Charney: We've always defined alternatives across three different buckets. The first is an alternative strategy. The second is an alternative asset class. And the third is an illiquid asset class.
For an alternate strategy, generally a fund would have to have some sort of hedging characteristic to it. For instance, a long/short equity fund can hedge 20%-50%.
For an alternative asset class, we're looking at asset classes that are uncorrelated to the market. … Currencies is a good example.
Then finally, an illiquid asset class that isn't really applicable to the '40 Act mutual fund space, but something like private equity or venture capital, we define as alternative as well.
That breaks down into seven different categories in the open-end fund universe that Morningstar defines as alternative, and those are bear market, multialternative, managed futures, market neutral, multicurrency, long/short equity, and non-traditional bond, which is a hybrid category that has some alternatives and some traditional funds as well.
Stipp: We've seen assets flowing into a lot of these different kinds of alternative mutual funds. In fact, there is now over $300 billion of assets in alternatives. What do you think has been the reason that they've seen the growth that they've seen?
Charney: The reason has evolved and changed over time. Part of the asset spike was following 2008, when investors were generally worried about getting into the market. Back then, long/short equity strategies were really popular. These funds had a much lower beta and had hedging characteristics to them.
Another strategy that has gained popularity as investors are looking for new sources of return are some option strategies. Bonds haven't really been yielding a whole lot, although Treasuries have been declining. People are worried about rising interest rates, and so option strategies are a good place to look.
Finally, I think investors have been fearful that rates are going to rise. The non-traditional bond category has gained quite a lot of assets, and some of these funds can actually short duration. The PIMCO Unconstrained Bond Fund, for example, can actually go negative three years of duration and potentially gain if interest rates go up.
Stipp: Those funds give the managers a lot of latitude, depending on what the market situation is, to change the character of the portfolio.
If I'm thinking from a portfolio perspective as an individual investor, how I would want to allocate assets to alternatives? What place would they take in my portfolio? And what do I need to be mindful of?
Charney: This year, Morningstar and Barron's did the 8th Annual Morningstar and Barron's Alternative Investment Survey. One of the things we found is that most investors allocated between 6% and 20% to alternatives, and that was a survey done with advisors as well as institutions.
One of the things that I think investors need to be mindful of is, don't just invest in alternatives to lower a portfolio's beta. You can lower a portfolio's beta very simply by just selling some securities and moving into cash. So, [an alternative] really has to have some sort of unique characteristic to it, and generally when we think about unique characteristics, we think about low correlation. So a long/short equity fund that has a very high correlation to the S&P 500 can generally be replicated by a combination of S&P 500 and cash. So, low correlation is definitely one of the key characteristics to look at.
Stipp: What about how this investment would play with the other kinds of investments that you have in your portfolio?
Charney: That's a really important point. It is true that different alternative funds correlate to different aspects of one's portfolio. Let's say you have 80% of your portfolio in equities, but you're really worried about that 20% fixed-income sleeve. So you take some of that 20%, and you allocate it to nontraditional bond funds. Well, there are some nontraditional bond funds that correlate very heavily to equities, and you actually did yourself a disservice there. You'd be less diversified by doing a move like that. So, it is very important to look at how alternatives are interacting with different funds within your portfolio as well as the correlation amongst the constituents of your portfolio.
The last thing you should generally look at is, alternatives should improve the risk-adjusted returns of your portfolio. Long-term the market has a Sharpe ratio of roughly 0.4. So you'd want to look for alternatives that have at least that high of a Sharpe ratio, maybe even slightly higher.
Stipp: Morningstar covers 70 alternative funds, and some of those have a Medalist rating, which we would consider to be likely to outperform their peers looking forward. How do you as an analyst team decide, these are alternative funds worthy of investors' attention because they are very good in their categories?
Charney: We currently, as you said, have 70 funds that are rated. Twenty-one of those funds have a Bronze, Silver, or Gold rating, and that actually comes out to only 4% of the alternative universe. So we are definitely very conservative and very picky for funds that we select [for Medalist ratings].
We use the same five-pillar process as the rest of fund research at Morningstar. We're looking at people, process, parents, performance, and price.
Generally, when we look at people we try and find managers that have had some alternative experience, including shorting or hedging experience.
In terms of performance, one of the things that we look for is performance of the short portfolio as well as performance of the long portfolio. We're looking at alpha as a whole, and are they making good security-selection bets?
With price, these funds tend to be more expensive; I would say probably 40% to 50% more expensive than their traditional peers, but we're definitely looking for some of the cheapest constituents.
Finally, for parent, we look for fund companies that are very good at constraining some of their alternative fund launches. There are definitely some fund companies out there that see alternatives as the next big moneymaker, and at Morningstar, we're trying to look for those firms that have been in alternatives a long time and have a proven track record in managing alternatives.
Stipp: Those that have been thoughtful about their fund launches.
Stipp: We know at Morningstar that there are great funds that are used poorly by investors, because they get in at the wrong time and get out at the wrong time. If I'm thinking about getting exposure to alternative funds, what should I know as an investor going in? What kind of mindset should I have, so that I can use these investments well?
Charney: I think you should be comfortable and familiar enough with the strategy that you're going to ride it out. Following 2008, a lot of investors got into managed futures funds because the asset class went up about 8% in 2008 and did very well, and subsequently it had a couple of really poor-performing years. Same thing with a big fund in the long/short equity category, Mainstay Marketfield. It had done really well for many years, and we saw a lot of hot assets move into it. As performance has subsided, investors have pulled back. Definitely, investors haven't been very good at timing these funds. So I would say that investors should be comfortable enough with the strategy to understand that they should ride it out, through thick and thin.
Stipp: Josh, very good insights on an asset class that a lot of folks probably are still just learning about. Thanks for joining me today.
Charney: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.