The Year in Alternative Funds

The news in late December 2015 that Whitebox Advisors, a Minneapolis-based asset manager, would be closing its three liquid alternative funds in 2016 added a fitting denouement to a bumpy year for alternative-strategy mutual funds. Whitebox was a well-known hedge fund firm that had entered the mutual fund world with some fanfare in 2011, on the strength of the reputation of the firm's founder, Andrew Redleaf. After some early success, Whitebox Tactical Opportunities WBMIX reached as high as $1 billion in assets. But after poor performance in 2014 and devastatingly bad performance in 2015 (negative 21% for the year), investors pulled assets in droves, forcing the firm to shutter its lineup.

During the past few years, many hedge fund managers have moved into mutual funds, lured by the promise of a new investor base and source of revenues. Many have found it a tough go, however. Whether it is the challenging global financial markets, the liquidity and leverage limitations of 1940-Act mutual funds, and/or the difficulties of managing money in a daily liquidity environment, performance success has been hard-won.

Don't believe the reports that fund closures like Whitebox are sounding the death knell for liquid alternatives. The rationale for incorporating lower-correlation, lower-risk strategies in portfolios hasn't gone away. Nor have the other market forces leading to the rise of liquid alts in the first place. What's taking place is the natural sorting-out of a segment of the mutual fund industry that experienced rapid growth and has become to a certain degree oversaturated. The funds that survive, and to which investors should gravitate, are those with strong institutional backing; sustainable, risk-aware investment processes; and a focus on costs and other investor-friendly behaviors.

Flows Down, but Not Dire The Whitebox closures were not an aberration. 2015 saw the most closures ever among Morningstar's alternative categories, at 33 (the three announced Whitebox closures would be on top of that figure). Of course, this number is also off of an all-time high in the number of funds in the universe, with particularly rapid growth in 2013 and 2014. The number of distinct funds across Morningstar's main alternative categories grew from 136 in 2007 to 559 at the end of 2014. Assets, meanwhile, skyrocketed from $46.5 billion at the end of 2008 to $315 billion by year-end 2014. It makes most sense to view the recent spate of closures as the retrenchment of a market where supply has exceeded demand.

Moreover, while fund launches were down from the banner years of 2013 and 2014, they were still notably positive with more than 70 new funds, in line with the numbers launched in 2011 and 2012. On a net basis, liquid alt mutual funds still saw positive growth in the number of funds offered.

Organic growth rates are another sign that things may not be as dire as reported. Alternative funds' organic growth rates have been among the most consistently positive of the broad Morningstar Category groups; and on an absolute basis, they were decidedly down in 2015, at 0.51%. On a relative basis, however, the numbers don't look too bad. In fact, the organic growth rates for alternatives was the highest of all the broad categories, within what was a fairly narrow range. (U.S equities had a negative 0.36% growth rate, by comparison. The worst was commodities, at negative 5.2%.) And despite subdued flows overall and several notable cases of outflows--

Performance Challenges Across the Alternative Categories As with most of the investment world in 2015, alternatives encountered tough sledding. All of the major alternative categories were in the red for the calendar year, though generally by only a percentage point or two. Unlike with equity or bond funds, it's harder to peg performance of alternative funds to specific asset classes or sectors, because the alternative categories tend to be assemblages of strategies, and many managers have the flexibility to invest in any asset class, as well as to go long or short. As I have discussed in the past, there tends to be greater dispersion in many of the alternative categories than in equity or fixed-income categories that are often constrained by style-box definitions; thus, while alternative category averages give a broad-brush picture of performance, many funds significantly outperformed or lagged the averages.

For long-short equity funds, spreads between global and domestic stocks, as well as between large/small and growth/value styles, did not work in managers' favor. The long-short equity category exhibits more international and small-cap exposure than the S&P 500, contributing to the category's underperformance relative to a 50% S&P 500/50% cash benchmark. Moreover, many long-short managers take short positions on what they consider overpriced growth stories such as

Multialternative and managed-futures funds both have the ability to capture global trends, though managed-futures funds typically follow systematic trend-following strategies while multialternative funds may pursue discretionary global macro approaches or more-static multistrategy designs. In both cases, currencies and commodities played a relatively greater role than in equity-oriented funds. Managers who were able to get on the right side of the strong dollar or the short side of commodities generally benefited; some funds were hurt by the Swiss central bank's unexpected removal of the cap on the Swiss currency. (Funds in the multicurrency category, naturally, were also affected by their currency positioning, most of them detrimentally based on their short-dollar bias.) Managed-futures funds displayed their noncorrelated features during the rough third quarter, when the category earned a positive return, but other periods were less friendly to trend-followers.

AQR's funds did well across both categories.

Within the usually sedate market-neutral category--managers hedge out most market exposure, usually leading to modest returns predicated on security selection and strategy execution--there was also a wide range of returns. AQR Equity Market Neutral QMNIX (which employs leverage) returned a scorching 17%, while at the other end of the category

Despite a record year for merger activity, merger-arbitrage funds (a subset of the market-neutral category) were no sure thing, owing to a number of significant deal breaks and some resulting spread widening. The best-performing merger-arbitrage fund, SilverPepper Merger Arbitrage SPAIX, gained 8.50%, while Silver-rated

And finally, bear-market funds proved once again that they are ill-advised investments for most individual investors. The category lost 5.24% in 2015, more than the simple inverse of the stock market, because of the leverage used by some funds. Yes, the funds had their moment in the third quarter, with the category average up 13% when the S&P 500 declined 6.4%, but it would require immaculate timing to pocket those gains and get out in time. Other alternative strategies--or even holding cash--provide more sensible ways to hedge against stock market declines.