Introducing the New Alternative Morningstar Categories
We've split, retired, and merged the old alternative categories into new and existing 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.
Three main objectives are driving the alternative category changes:
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:
And here are the new alternative categories:
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.
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:
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:
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.
Erol Alitovski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.