Introducing the New Alternative Morningstar Categories

In order to better define the ever-evolving alternatives landscape and improve the information available to investors when considering these investments for their portfolios, we are enhancing the Morningstar Category classification system, with the changes going into effect on April 30, 2021.

Morningstar Direct and Office clients can find the updated category classification methodology here and an FAQ here.

Three main objectives are driving the alternative category changes:

1. To differentiate between strategies that aim to minimize exposure to traditional market risks (which we define as alternative strategies) and those that may employ similar instruments and techniques--such as heavy use of derivatives, shorting, and options overlays--while maintaining exposure to traditional market risks;
2. To help investors make more relevant comparisons between alternative strategies that are driven by similar market dynamics and pursue similar objectives by splitting large, heterogeneous categories into smaller, more focused peer groups;
3. Align alternative category classifications across regions to provide greater consistency globally.

What's Changing?

The list of category changes is long, but all of them tie back to one of those themes. Before we explore the changes in more detail, here's a summary:

• The long-short equity category remains intact but is moving to the new nontraditional equity U.S. category group within the equity global broad category group.
• The long-short credit category is being retired, and funds in this category are moving to the nontraditional bond category.
• The options-based category is splitting into two new categories: derivative income (in the nontraditional equity U.S. category group) and options-trading (staying in the alternative U.S. category group).
• The volatility category is being retired, and funds in this category are moving to options-trading.
• The multialternative category is splitting into two new categories: multistrategy and macro-trading.
• The market-neutral category is splitting into three new categories: equity market-neutral, event-driven, and relative value arbitrage.
• The managed-futures category is being renamed systematic trend in order to align category names globally.
• The single-currency category is moving to the taxable-bond U.S. category group. The multicurrency category has been retired, with absolute-return-oriented strategies moving to macro-trading and benchmark-oriented strategies moving to the world-bond or emerging-markets local-currency bond categories, as appropriate.
• Trading categories are being reclassified in the miscellaneous U.S. category group.

And here are the new alternative categories:

• Equity Market-Neutral
• Event-Driven
• Macro-Trading
• Multistrategy
• Options-Trading
• Relative Value Arbitrage
• Systematic Trend

What Is Alternative?

Alternative investment strategies attempt to expand, diversify, or eliminate the dominant risk factors contained in traditional market indexes, such as equity, credit, and rates indexes. These strategies tend to focus on capital preservation, long-term portfolio diversification, or enhanced risk-adjusted returns in isolation or combination. Application may be across single or multiple asset-classes using a variety of investment techniques.

These strategies not only have the ability to short securities, but they also aim to provide access to differentiated and/or diversifying exposures with a high degree of flexibility and little correlation to traditional market indexes. Many managers in traditional asset classes, particularly in the fixed-income and asset-allocation categories, routinely utilize short exposures, typically via exchange-traded funds or derivative instruments, for risk-management purposes or as an additional source of excess return. While such measures may modify a portfolio's risk levels, these strategies still primarily provide investors exposure to traditional asset classes. As such, shorting, and derivative use more broadly, should not be viewed as the defining attribute of alternative strategies.

Strategies such as long-short equity, long-short credit, and market-sensitive options-based funds tend to modify traditional equity or credit risks rather than diversify them. As such, these strategies are better considered alongside other equity, fixed-income, or allocation strategies. For similar reasons, we're no longer classifying benchmark-oriented currency or trading strategies as alternative.

For example, long-short equity has long been considered an alternative strategy by many. However, as we think about a strategy's ability to diversify or eliminate traditional market risks, long-short equity strategies often fall short because their returns tend to be highly correlated with equity market indexes. The strategies' short exposures may help temper losses in downturns while still allowing them to participate in some equity market upside, but these strategies can be thought of as modifying a portfolio's equity market exposure rather than diversifying it.

The long-short equity category will persist, and investors will still be able to calculate category averages and other statistics relevant to the peer group. However, by moving it to the new nontraditional equity U.S. category group, we are signaling to investors that these strategies should be considered as part of a diversified portfolio's equity allocation.

We're also dividing the old options-based category--historically one of the most heterogeneous of the alternative categories--to better distinguish between strategies that we'd describe as alternative versus those that are oriented toward providing exposure to traditional market risk. Some strategies are highly correlated to equity markets, while others are based on options market volatility structures. Strategies that largely rely on options contracts to generate incremental income on top of traditional equity market return drivers are now classified in the new derivative-income category, which is included in the nontraditional equity U.S. category group, while less market-sensitive, relative-value-oriented strategies are classified as options-trading, an alternative category. As a rough guideline, expect to see strategies with a trailing equity beta (a measure of market risk) of less than 0.6 fall in the options-trading category and options-heavy strategies with a beta value between 0.6 to 0.9 fall in the long-biased derivative-income category.

Narrowing It Down

Some of our previous alternative categories were broad-reaching and contained a heterogeneous mix of strategies. Our new category framework breaks larger, sprawling categories into more narrowly defined groups. By grouping funds that employ similar investment strategies and return drivers together, we expect to see less performance dispersion within categories. Investors will also be able to make more meaningful risk and return comparisons along with a more relevant comparison of fees between strategies.

For example, the multialternative category is splitting into two smaller categories: multistrategy and macro-trading. Multistrategy funds allocate capital to a mix of alternative strategies (at least 30% combined), as defined by our alternative category classifications. By contrast, macro-trading strategies focus specifically on trading a broad range of securities and instruments based on macroeconomic analysis. Multistrategy funds may include macro-trading strategies as one of several alternative strategies in their portfolios. Similar to long-short equity and other strategies discussed above that mainly offer exposure to traditional market risks, a handful of multialternative strategies are moving to the allocation categories.

Here's where the five biggest multialternative strategies land in this new scheme:

• Blackstone Alternative Multi-Strategy BXMIX, the largest fund in the old category, occupies the new multistrategy category along with BlackRock Systematic Multi-Strategy BIMBX and Goldman Sachs Absolute Return Tracker GJRTX. These strategies have their own distinct implementation, but all three allocate capital across or try to replicate several alternative strategies.
• The next largest strategy in the old category, BNY Mellon Global Real Return DRRIX, is moving to the tactical-allocation category since it primarily trades across traditional risk premiums while hedging with derivatives. The strategy's use of derivatives or other hedging techniques to modify traditional exposures does not qualify as an alternative strategy in our new framework. Other strategies in this position are typically long-biased in nature, even though the managers do have some latitude to use alternative strategies on the margin.
• Catalyst/Millburn Hedge Strategy MBXAX, the fifth-largest strategy in the old category, will move to the macro-trading category. Macro-trading strategies (systematic or discretionary) trade a broad range of securities based on a combination of macroeconomic indicators and fundamental data for security selection. Although uncorrelated over a full market cycle, macro strategies tend to be directional over short periods of time, resulting in episodic correlation and the potential for significant drawdowns.

Similarly, the market-neutral category is splitting into three categories--equity market-neutral, event-driven, and relative value arbitrage--to help investors make more relevant comparisons between strategies. While all three attempt to minimize systematic market risk, they go about it differently. Equity market-neutral strategies attempt to profit from long and short stock selection decisions, event-driven strategies attempt to capitalize on security price changes that arise from certain corporate actions (such as mergers), and relative value arbitrage strategies seek out pricing discrepancies between related securities across one or more asset classes. Here's how this impacts some of the largest funds in the old market-neutral category:

• Calamos Market Neutral Income CMNIX, the largest strategy in the old category, is moving to the new relative value arbitrage category. The challenges of implementing these strategies in a mutual fund structure mean that there are fewer mutual funds and ETFs in this category, even though it's a more prominent mapping for private hedge funds and UCITs vehicles. This strategy focuses on convertible arbitrage, but other relative value arbitrage strategies include volatility arbitrage, fixed-income relative value, and capital structure arbitrage.
• BlackRock Event Driven Equity BILPX, Merger Fund MERIX, and Arbitrage Fund ARBNX are the three next largest strategies and fall into the new event-driven category. Event-driven strategies typically will hold positions that involve a hard catalyst such as a merger, which means idiosyncratic corporate actions have a greater impact on returns, as does the overall market climate for corporate actions.
• Pimco RAE Fundamental AdvantagePLUS PFATX, the fifth-largest in the old category, lands in equity market-neutral, where managers typically aim to reduce systematic risk (with a trailing equity beta below 0.3, generally) and instead emphasize security selection, with profits dependent on their ability to make advantageous long and short decisions.

More to Come

This new category framework provides us with a springboard for doing further research into the advantages and drawbacks of different types of alternative strategies, how to assess whether alternative managers are getting the job done, approaches worth considering as a complement to traditional asset classes, and those worth avoiding altogether. Expect to hear more from us on these topics in the months ahead.