An Early Read on the 2014 Morningstar Alternatives Fund Manager of the Year

As part of the early handicapping for Morningstar's Fund Manager of the Year awards, we've run screens across the various categories (awards are given for domestic-stock, international-stock, fixed-income, allocation, and alternatives managers) to identify potential front-runners. Before turning to the alternatives group, I want to caution that these results are quite provisional; with two months remaining (when we ran the data) in what has been a very volatile year, it's quite possible that additional candidates could emerge or that someone on the current long list could experience a hard stumble.

Some additional caveats are in order when it comes to alternatives fund managers. For one thing, the list of Morningstar Medalists in alternatives categories (a baseline criterion to be considered for the FMOY award) is small, numbering only 24, which leaves us a limited initial candidate pool. Moreover, when considering the performance of alts managers, it's important to consider the role typically intended for alternatives within investor portfolios. Most alts funds are hedged relative to standard stock and bond indexes, and many advisors and investors view them as diversifying components of a portfolio. Thus, a simple screen based on funds' year-to-date returns and relative category ranking captures only part of the picture. We've extended our filters to examine Sharpe ratio, beta, and correlation.

Finally, it bears mentioning that while we typically look for managers who not only have had a great calendar year but a stellar long-term track record, when it comes to alternatives long-term may mean only five years, and most alternatives funds have emerged in only the past couple of years. We still lean toward managers with impressive histories--whether at their current fund or running similar strategies in other structures--but it's rare to find an alternatives fund with 10 years of history under a single manager.

Caveats aside, the burst of new alternatives vehicles over the past few years means more options for investors, and more managers whose strategies are worthy of investors' attention and dollars. The managers mentioned below have all delivered so far in 2014 on the objectives investors seek in alternative investments, and they may be in the running when it comes time to make the official nominations.

Repeat Customers
Two of the funds on the list have been nominated before, and one was in fact our inaugural alternatives winner in 2012. It isn't surprising to find some repeat names on the list. Managers who have proven, repeatable investment processes are likely to hit the radar in multiple years, as happens frequently in the other asset classes.  TFS Market Neutral , the 2012 award winner, uses a heavily quantitative process within a market-neutral structure; the fund has generated fairly consistent alpha by identifying 10 different trading models and continuously updating its models over time. The fund's small-cap bias has been a detractor in 2014 (as the Russell 2000 is lagging the S&P 500 by 9.1% this year through October), but its 1.75% return through Nov. 7, 2014, is 120 basis points ahead of the category average. The six portfolio managers, including firm co-founders Rich and Kevin Gates and Larry Eiben, invest significantly in the fund.

 Robeco Boston Partners Long/Short Research (BPIRX) was a nominee for Alternatives Manager of the Year in 2013, and it's extended its impressive track record thus far in 2014. This analyst-run fund allots separate sleeves to nine different analysts, overseen by CEO Joseph Feeley and research director Eric Connerly. The fund has shown notable success in its shorting process relative to peers, and its 5% return through Nov. 7 ranks in the category's top quartile, with shorts once again providing positive alpha. Over the trailing three years through the end of October, the fund's Sharpe ratio of around 2.0 nearly doubles the category's risk-adjusted return.

Robeco Boston Partners has a long history running alternative strategies, and its flagship alternatives fund is actually  Long/Short Equity (BPLEX), which launched in 1998. This year the fund makes it into the early running for consideration on the strength of its 6.6% year-to-date return, among the top 15% in the long-short equity category. The results are more impressive when considering the fund's relatively low beta of 0.26, amounting to alpha of around 7%. Lead manager Bob Jones (one of the founders of Boston Partners, which was acquired by Robeco in 2002) has historically exhibited a small-cap value bias, though lately the fund has taken more of an all-cap approach. On the short-side, Jones targets overhyped "concept" stocks with unstable business models. Shorting smaller-cap names can be difficult and expensive, but management has had considerable overall success here: After losing 21% in 2008 (more than the average peer), it zoomed an astounding 81% in 2009 thanks to various small-cap long wagers. Investors should expect more volatility here than with its sibling, and it also features a significantly higher price tag.

Newcomers
The next two funds on the long list are new as Morningstar Medalists, each having received its first Morningstar Analyst Rating earlier in 2014, but they aren't new to the alternatives investment industry. Indeed, part of the reason that Gotham Absolute Return and John Hancock Alternative Asset Allocation receive Positive analyst ratings is that their managers have considerable experience running alternative strategies, a quality often lacking when it comes to alternatives.

 Gotham Absolute Return (GARIX) portfolio managers Joel Greenblatt and Robert Goldstein have run a concentrated long-short equity hedge fund at Gotham Capital for over 25 years, and the process translated very easily to a mutual fund structure. The strategy is rules-based, but based on heavily qualitative inputs for scrubbing company financial statements to remove accounting gimmicks. Management buys approximately the 400 highest-ranked stocks and shorts the bottom 300. Greenblatt and Goldstein can adjust the fund's net exposure, and they've benefited on a relative basis from maintaining a higher beta in 2014 (0.69 for the fund versus 0.52 for the long-short category). But the fund has also produced positive alpha of more than 1% this year.

 JHancock Alternative Asset Allocation (JAAAX), the sole multialternative fund to make this list, has been around since 2008 but has existed in its current format since December 2010, when it began including strategies that can go short. Managers Bob Boyda and Steve Medina, who head up Hancock's Portfolio Solutions Group, are firm veterans with a long history of selecting subadvisors and allocating funds across a portfolio, as they do in this fund of funds. Key pieces to the puzzle here are two absolute return strategies, JHancock Absolute Return Currency and  Global Absolute Return (JHAAX) , as well as  Short Duration Credit Opportunities . Absolute Return Currency, subadvised by First Quadrant, has been a big contributor to this year's performance, as unlike many currency funds this one has a number of long-dollar positions. Boyda and Medina have also been lighter than many category peers in their long/short equity and event-driven exposure.

A Surprising Name
Perhaps the most surprising fund to warrant early consideration for Alternatives Manager of the Year is  Vanguard Market Neutral (VMNFX). Vanguard is not a fund firm one typically associates with alternatives, but this fund has been around since 2004 and fully under the management of Vanguard's quantitative equity group since 2010 (previously  a portion of the fund's assets were subadvised by Axa Rosenberg). Comanagers James Troyer (who ran the fund solo from 2010 to mid-2012), Michael Roach, and James Stetler rank stocks on five factors--valuation, growth, quality, momentum, and management decisions--betting long on those that rank best and short those that score poorly. With an expense ratio for the Investor shares of 0.25%, the fund carries a huge cost advantage over most market-neutral peers, helping it to an alpha of 2% through the end of October. With experienced management, low fees, and a rock-solid parent firm behind it, this fund is no flash-in-the-pan.