The Must-Haves of Multialternative Funds

Morningstar's multialternative category, which houses 83 one-stop-shop, multistrategy alternative mutual fund solutions (as of July 31), is one of the fastest growing. Of the 83 category constituents, 21 funds launched in 2011; so far in 2012, 11 more have made their debut. In terms of assets, these multistrategy alternative funds have garnered $4.38 billion in 2011 and $1.87 billion this year (through July), substantially more than other alternative categories. The driver of this demand is clear--investors and advisors are confused about how to allocate to alternatives and are looking to third parties to help them. Here are a few pointers to help find a multialternative solution that's right.

Low Correlations
In order to diversify a traditional portfolio, one must choose investments that exhibit low correlations to what currently resides in the portfolio. The definition of "low" is up for grabs, but the lower the better. As most of the risk in a traditional "60/40" portfolio comes from stocks, it's prudent to find a multialternative fund that has a relatively low correlation to equities. Of the 36 multialternative funds that have been around at least a year (through July), 22 exhibited a 52-week correlation to the S&P 500 index north of 70%. Many investment professionals would not consider that low. Of course, correlations are backward-looking and unstable, so it's best just to use common sense. Does the multialternative fund contain large allocations to long-short equity or nontraditional bond strategies that take on a significant amount of equity or credit risk? If so, it will not adequately diversify your portfolio. Strategies that are more diversifying include managed-futures, currency, and market-neutral or arbitrage.

Sensible Subadvisors
When choosing a multialternative fund, it's important to pick one that justifies the many layers of fees. Most multialternatives are multimanager funds (whether the structure is a fund of funds or a fund of separate accounts). The primary value proposition of a multimanager fund is manager selection--the fund of funds' manager must be able to demonstrate the ability to select the appropriate strategies at the right time and to allocate to the best managers within those strategies. But many advisors are just as good at manager selection as the multialternative manager, especially when it comes to 1940-act registered vehicles (after all, advisors must earn their own management fees). Whereas investments in unregistered hedge funds may be difficult to find and may require many hours of operational due diligence (to rule out fraud or business insolvency, for example), good mutual fund investments are neither difficult to find (Morningstar now publishes qualitative ratings on alternative funds) nor likely to be fraudulent (with SEC oversight, independent auditors, custodians, and administrators, and transparency into the holdings).

So advisors may want to focus on the multialternative funds that don't simply allocate to other mutual funds (or separate-account versions of existing mutual funds). There are several multi-alternative funds run by hedge fund of fund managers that focus on hedge fund strategies. Wilmington Rock Maple Alternatives (WRAAX) is one such fund.

Reasonable Fees
Let's face it, no one works for free. But in our current low-return, high-volatility environment, the more you pay for fees, the harder it will be to make any money at all. When comparing fees of multialternative funds, it's important to look at the prospectus net expense ratio, which incorporates acquired fund fees. The most expensive funds in the category are funds-of-hedge-fund managers (Altegris Macro Strategy , for example), which charge 4% or more. The median fund charges 1.96%, though, so there are more reasonable options. Cheaper is not always better, however. Some multialternative funds attempt to dilute the sting of fees from alpha-producing managers with allocations to cheaper beta-heavy strategies (tactical ETF or long-only strategies that the multialternative manager hedges).

Some Better Options
Although there are few standout options in the multialternative category, there is one that we like better than the rest.  IQ Alpha Hedge Strategy  (rated Bronze) is a hedge fund replicator with a twist--it uses ETFs to replicate the returns of six different hedge fund strategies (including arbitrage, market-neutral, and global macro) and weights these strategies according to momentum. Its returns since inception (2.7% annualized through July) rank it among the top in the category, and its correlation is low relative to other multialternative funds (0.63 using monthly returns through July).

Another option would be to put a simple portfolio together yourself. A three-fund alternative portfolio would be a good place to start. An equally weighted combination of managed-futures, market-neutral, and long-short equity should yield a relatively low correlation to traditional portfolios but at the same time allow for some kind of positive return. For managed-futures, we like  AQR Managed Futures Strategy (AQMIX). For market-neutral, one of the funds we like is  JP Morgan Research Market Neutral (JMNAX). And for long-short equity, we like  Marketfield (MFLDX). Since the January 2010 inception of the managed-futures fund (the newest fund), this combination would've yielded both positive returns (2.3% annualized through July) and a correlation of 0.69 to the S&P 500 (using weekly data through July). All for the reasonable average-weighted price tag of 1.25%.

This article orginally appeared on MorningstarAdvisor.com. To learn more about our Alternatives research, visit MorningstarAdvisor's Alternatives center.