Investors Seeing Alts Are No Free Lunch

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. So-called alternative mutual funds have disappointed since they began to proliferate in the wake of the bear market. Joining me to discuss that topic is Russ Kinnel, he's director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: You're welcome.

Benz: Russ, let's talk about alternative investments, specifically alternative funds. How does Morningstar categorize alternative funds, how do we decide what is an alts product?

Kinnel: Well, the broad definition we consider is really strategies that have low correlations with traditional equity or fixed-income strategies.

Benz: How do you determine that?

Kinnel: You can look at correlation, you can look at strategies. Obviously, a lot of alts funds have either short or at least some short positions. Others will have all sorts of hedge fund strategies, like futures strategies and others that have low correlations again with equities and fixed income. There is really a lot of ways to do that, a lot of strategies, and it seems like there is a new one coming out every day.

Benz: OK, so it's a broad umbrella. You recently wrote a piece in Morningstar FundInvestor where you looked at the performance of alternatives. As I said at the outset, a lot of these products did come to market in the wake of the bear market. When you look back on the history of alts products, what you wrote is that performance on the whole is pretty disappointing. Let's talk about that.

Kinnel: That's right, performance hasn't been great, and we can tell that investors are disappointed because a lot of alts funds have a surge in assets and then it comes down, much more so than in other categories. So, for instance I look back at February 2014 to today, and most of the top 20 alts funds have had declines in assets since then. Not true at all in the other categories, and in fact three of those funds aren't even around today. So, there is just a much bigger churn both in terms of existence of alts funds, but also in alts investors' attention. They seem to move from one fund to another, much more rapidly than the more traditional spaces.

Benz: The past several years, though, arguably, are not a period in which we would expect to see alternative investments perform especially well, especially if investors are comparing them to, like, their pure stock fund, right?

Kinnel: That's right. I think to a degree, part of the problem is investors expecting this free lunch. When an alts fund comes out often people expect that it will somehow magically keep up with the equity markets in rallies and then loose nothing in a down market, and of course that's not possible. So, part of this is just expectations are too high.

And other part of it is fees are too high when yields are low. A lot of alts funds have strategies geared off of some kind of fixed income. When yields are really low, but fees are really high, it's awfully tough to produce a good return.

Benz: It's a bad combination for sure. So, as you look across the universe of alts funds, what's your advice to investors? Do they need these types of products in their portfolios?

Kinnel: I don't think you do need it. I think some investors can make good use of it, because they are low correlation with traditional investments and there is some value there. There are some good strategies, some good managers, even a handful of reasonably priced funds. So, you can do it, but I don't think you absolutely need it, and if you are really confused by the strategy it's probably not a good one to use.

Benz: So, make sure you understand whatever you are looking at. Assuming I am determined to forge ahead and add some sort of an alts product to my portfolio, maybe like 5% or 10% of my portfolio, what are the factors I should look for? You've hit on the virtue of low costs, what are the other things I should have in mind?

Kinnel: I think some of it is the same stuff you'll look for in any fund--you want a good manager, you want a good strategy. You want to see a good track record. I think in alts it's particularly valuable to have that track record. If nothing else than to just have realistic expectations. Especially if it goes back to the bear market, but just to look year on year what has it done. Because I think again part of those unrealistic expectations come from funds that have a one- or two-year track record. Maybe they have a great return right out of the gate and we get the wrong idea. So at least look at those calendar year returns, at least get some idea of what to expect.

Benz: You also said it's key to make sure you understand the strategy.

Kinnel: By all means. There are some incredibly complicated strategies in alts land. If you really can't understand it, then its going to be hard to use it correctly.

Benz: Good point. Thank you, Russ, for being here to discuss this research.

Kinnel: You are welcome.

Benz: Thanks for watching I'm Christine Benz from Morningstar.com.