Last year's market rally defied gravity. Investors, looking to diversify, have been on the prowl for strategies that offer lower correlation to traditional asset classes, like stocks and bonds. It's not surprising, then, that investors are turning to alternative mutual funds in droves. The group, which encompasses strategies such as long-short equity, market neutral, and managed futures, is considered "off the style grid." True, many of these funds hold plain-vanilla assets, but managers typically employ complex techniques, such as shorting, that alter the fund's DNA. In 2013, through November, investors poured $88.6 billion into alternative strategies; assets increased an astounding 51.4%. Although there are now 431 alternative mutual funds in Morningstar's alternative categories, total assets still constitute less than 3% of the entire mutual fund universe. Alternative strategies, however, don't offer the promise of gangbuster returns; instead, investors should expect a smoother ride with the possibility of better risk-adjusted returns. Morningstar's 2013 alternative nominees delivered exactly that.
This year, our nominees provided a mix of superior risk-adjusted and absolute returns versus their peer groups. Funds within the same category, for instance, offer varying degrees of risk. Also paramount to the nominating process were strategy and asset-class characteristics. Virtually any long-biased fund that touched equities did well in 2013, for example. Conversely, managed-futures funds, which use momentum-based strategies, largely floundered last year. Therefore, peer group analysis was extremely important to avoid punishing (or rewarding) unlucky (or lucky) management teams. Overall, the nominations shared characteristics that are core to selecting any alternative mutual funds.
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Josh Charney, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.