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Fund Spy

3 Surprising Findings from Morningstar's Alternatives Survey

Increased institutional use of mutual funds is among the surprises in this year's survey results.

Last week, Morningstar published its eighth annual survey, in conjunction with Barron's, of how alternative investments are used and perceived by advisors and institutions. Over the past half-decade, alternative investment strategies have hit the mainstream, with nearly $200 billion flowing into alternative fund categories (including non-traditional-bond funds) from the start of 2009 through 2013. Our annual survey has tracked the growing interest in liquid alternatives, not only among institutions, always an early and natural user of such strategies, but among advisors as well. This year's Barron's article can be found here (subscription required), and the full survey results can be found here. It's a 60-page presentation, chock-full of data and graphs, and I encourage those who are interested to read it in full.

I'll call out the three most interesting--and in some ways, surprising--findings in this year's survey. Each has implications both for the continued usage and growth of alternatives and for how individual investors should think about these strategies.

Even professional investors aren't sure how to benchmark alternatives.

OK, that's not exactly what the survey says, but it's the implication. One of our hot-topic questions this year was, "What type of benchmarks does your firm use to compare its alternative investments?" The top response, from both advisors and institutions, was "standard benchmarks." Surprisingly, the percentage of institutions that gave this response slightly exceeded advisors, 27% to 25%, even though institutions typically have access to more-sophisticated attribution metrics. The next two closest responses were "fund peers" (such as Morningstar Categories) and risk-adjusted analysis (which does not seem to be a benchmark per se). Cash, which many alternative funds (particularly market-neutral funds) list as their benchmark, was stated as a benchmark by only 6% of either respondent group.

This muddle of responses suggests there's a decided lack of agreement and even confusion about how to benchmark alternatives. Few strategies match up well with traditional benchmarks. Indeed, the purpose of most alternative investments is to provide low correlation with such indexes. Yet they remain the top choice even among institutional investors, presumably left standing as the best of a poor lot of options.

Alternative funds' strategies are diverse and don't conform with typical approaches to portfolio construction certainly, adding to the benchmarking difficulty. These attributes also pose a challenge to their continued success. As outcome- or solution-oriented investing becomes a bigger part of portfolio construction, it becomes even more important to come up with effective ways to judge the success of what can seem to be nebulous objectives. Investors rely on benchmarks to gauge the success of their funds, and everyone (Morningstar included) needs to work harder and think more creatively about which benchmarks are most meaningful and useful to investors.

Lacking a firmwide expertise in alternatives is no obstacle to the appeal of an alternatives strategy.

When asked to select the most pertinent factors in selecting an alternative product, the response "firm's core competency includes alternatives" ranked third-lowest, garnering positive responses from only 6% of both advisors and institutions. Receiving the most votes were manager/team experience in alternatives (20% of institutions and 17% of advisors) and investment process (19%/13%) with several other factors sharing 10%-15% of the votes apiece.

Certainly, the top factors selected by respondents are reasonable and appropriate, and it makes sense that no single factor dominated, given that strategy selection should be a multifaceted process. But the very low weighting assigned to a firmwide core competency in alternatives is a bit surprising--and somewhat encouraging to the many new sponsors of alternatives mutual funds. Newcomers range from startup boutiques to established hedge fund firms to mutual fund powerhouses (in some cases by hiring an established hedge fund manager and in other cases building from internal resources). The results suggest that if a manager has a demonstrated track record and pedigree running a well-defined strategy, advisors will be willing to give the fund a look even if the firm has not historically done much in alternatives.

Increasingly, institutions are fans of alternative mutual funds.

It's not all that surprising that mutual funds would continue to grow as a vehicle of choice for investing in alternatives, given the flows into the strategies and the number of new launches. Simply put, expanded interest plus greater choice equals higher usage. What is somewhat surprising, however, is the growing preference for mutual funds from both advisors and institutions.

For instance, mutual funds leaped to 73% from 57% in the prior year's survey as the preferred vehicle among advisors for gaining access to long-short equity or debt strategies. Nearly half of institutions in this year's survey also cited mutual funds as the long-short vehicle of choice. And among institutions that have access to managed-futures strategies, mutual funds rose to 48% from 32% as the vehicle of choice. (More than 50 new managed-futures strategies have launched as mutual funds over the past four years.) Advisors choose managed-futures mutual funds more than half the time.

This last trend is unlikely to abate anytime soon. To the extent that advisors or institutions can gain access to a strategy that can closely or identically follow its process with daily liquidity, more frequent disclosures, and often lower fees, they'll take that mutual fund option nearly every time. Certain types of strategies will necessarily remain the provenance of traditional alternative structures--private equity and private debt come to mind here--but for the many more-liquid strategies that can still help investors achieve lower correlations and better risk-adjusted returns in their portfolios, mutual funds should continue to gain market and mind share.