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How Alternative Are Alternative Funds?

Correlation to stocks and bonds varies depending on the strategy used.

In the investing world the word "alternative" can be tough to pin down. Some people consider alternative investments to be any assets other than stocks, bonds, cash, or the funds that hold them. This might include asset types such as real estate, commodities, or even more esoteric investments such as wine or fine art.

But alternative investments also can refer to alternative strategies, or unconventional ways of investing in traditional instruments such as stocks and bonds. Managers typically employ complex techniques, such as shorting, that alter a fund's DNA. It's this definition that Morningstar uses to define its alternative fund category group.

As with more broadly defined alternative investment types, alternative funds often are aimed at helping diversify a portfolio away from the performance of traditional equity and fixed-income investments. Just as commodities may be used to provide exposure to an asset class that doesn't move in lockstep with stocks or bonds, so, too, an alternative strategy fund might be used to provide performance that does not mirror the market.

But how much diversification have these funds provided? To find out, let's look at the long-term and near-term track record with regard to correlation--that is, the degree to which asset types move together.

Defining Alternative Fund Types
Before we begin, let's clarify what we mean by alternative funds. Below is a list of some of the more popular strategies employed by these funds, some of which mimic strategies used by hedge funds.

  • Bear Market: Designed to profit if the market goes down by investing assets primarily in short equity positions.
  • Long-Short Equity: Invests a portion of assets in stocks the fund's managers expect will appreciate over time (long positions) as well as shorting those they expect will decrease in value.
  • Managed Futures: Seeks to capitalize on price momentum, mean reversion, or other strategies through the use of derivatives such as futures, options, and swaps, along with other investments.
  • Market Neutral: Uses long and short equity positions to offset one another in order to reduce systemic risk while emphasizing stock selection.
  • Multialternative: Uses multiple different alternative strategies and may tactically allocate assets among these.

Although some of these strategies have more overt diversification goals than others--bear market funds, for example, specifically aim to move in the opposite direction of the stock market--looking at correlation levels between these fund categories and the stock and bond markets can provide insight as to how each might be used in the context of a broader portfolio consisting of stock and bond investments.

Below are three correlation matrices that look at each of these alternative fund categories and their level of correlation to one another as well as to the S&P 500, a commonly used proxy for the U.S. stock market; the Barclays U.S. Aggregate Bond Index, a proxy for the U.S. investment-grade bond market; and the Barclays U.S. Long Treasury Index.

To compare two items on the list, just look for the first along the left-hand side and find the corresponding number of the second across the top. The shaded box where the two lines converge is the correlation level for the two items and represents the degree to which they have moved in sync over the given time periods.

A correlation of close to 1 means that the categories and/or indexes move in the same direction nearly all the time, while a correlation close to -1 means they move in opposite directions nearly all the time. A correlation close to 0 means there is little relationship between the two.

 Correlations, 2009-2013

Source: Morningstar

Looking at the first matrix, representing the five-year period from 2009 to 2013--which more or less overlaps with the current bull market--we see results both expected and unexpected. For example, it comes as no great surprise that the bear market fund category did its job, with a correlation to the stock market that approaches -1, thus providing strong diversification away from stocks. Managed futures and market-neutral also have provided good diversification relative to stocks as shown by correlations to the S&P 500 that are much closer to 0 than to 1.

However, the long-short and multialternative strategy fund categories generally have behaved more similarly to the market, each with correlations above 0.90 relative to the S&P 500. These higher correlations could be due to managers positioning their portfolios to capture more of the rising market as opposed to seeking a more defensive posture.

Meanwhile, all the alternative fund categories provided good diversification relative to our bond and Treasury market proxies. (Keep in mind that the past five years have seen dramatic growth in the number of alternative funds, so the earlier numbers are based on a smaller group.)

Correlations in 2013

Source: Morningstar

A look at the second matrix, encompassing just the year 2013, shows much higher levels of correlation between the managed futures and market neutral fund categories and the stock market (0.58 and 0.86 respectively versus 0.15 and 0.35 respectively during the five-year period). This would seem to suggest that, during a year in which the market bulls were firmly in control and the S&P 500 gained more than 30%, these alternative strategies followed the market's direction more closely than in some other years.

For the sake of comparison, let's also look at where correlations for these alternative strategy fund categories stood in 2008, as the bear market took hold.

Correlations in 2008

Source: Morningstar

Here we see that managed futures and market neutral funds were actually negatively correlated to the market at the time (again remembering that there were far fewer of these funds then than there are today). That suggests that managers of these funds by and large were not trying to follow the market that year.

What About Returns?
Although correlation statistics can provide insight with regard to the degree that fund categories and the overall market move together, they don't offer any guidance with regard to the strength or weakness of these movements. For this we'll turn to total return statistics for the trailing five-year period, as well as for last year alone.

S&P 500 (TR)
1-year return: 32.4%
5-year return: 17.9%

Barclays US Agg Bond (TR)
1-year return: -2.0%
5-year return:  4.4%

Barclays US Treasury Long (TR)
1-year return: -12.7%
5-year return:  2.3%

Alternative fund categories
Bear Market
1-year return: -34.4%
5-year return: -29.5%

Long/Short Equity
1-year return: 14.6%
5-year return: 9.2%

Managed Futures
1-year return: -1.0%
5-year return: -4.8%

Market Neutral
1-year return: 2.9%
5-year return: 1.4%

1-year return: 4.2%
5-year return: 5.9%

Given the market's strength over the past five years, it should come as no surprise that bear market funds, which have a high negative correlation to stocks, have gotten hammered. Meanwhile, alternative categories that are more highly correlated to stocks, such as the market neutral and multialternative categories, have eked out small gains in the 1- and 5-year time periods, but nothing on the order of the S&P 500's strong performance.

So why invest in alternative funds that have lagged stock market performance and that, in some cases, provide little in the way of diversification? One look at how alternative fund categories performed during the market meltdown of 2008 helps explain their appeal. That year, while the S&P 500 was losing 37%, market neutral funds lost less than 1% on average. The bear market category, in contrast to its performance since then, fared very well, gaining 30% for the year. Multialternative funds, on the other hand, struggled, averaging a loss of 22%.

Since then, assets have poured into alternative funds as risk-averse investors have sought ways to participate in the market while mitigating some of its most dramatic ups and downs. As a result, alternative funds have grown faster than any other fund category group--from about $62 billion in assets at the end of 2008 to $179 billion as of the end of 2013 (including alternative ETF assets).

For investors concerned with safety first, alternative funds' underperformance relative to equities during the bull market of the past five years may be less of a concern than their ability to protect against another market drop like we saw in 2008. As for their ability to diversify a traditional portfolio made up of stocks and bonds, the results, at least over the past five years, have been mixed. Investors interested in alternative funds should keep in mind that funds within this category group can be quite different from one another, and they should set their expectations accordingly. Here, as much as with any fund category group, there is no substitute for doing your homework and making sure you thoroughly understand a fund's strategy before buying.