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Rekenthaler Report

Evaluating Funds From the Portfolio Perspective

A different picture of the risk/reward trade-off.

Group Think
Reward, we are told, is inextricably linked with risk. Investors receive low returns from very safe assets. If they seek more, they must assume additional risk, thereby hazarding the possibility that they will receive less.

This is true, insofar as it goes. However, as Dr. Markowitz pointed out several decades ago, risk doesn't exist in isolation. If an investment tends to zig when an investor's other assets zag, it can stabilize a portfolio even if it is volatile. Conversely, a relatively tame security might fail to lower a portfolio's risk, if that security is highly correlated with the existing holdings. Context matters.

Such thinking underlies the new Morningstar Style Box for alternative funds. The company's existing style boxes, for stock and bond funds, eschew the portfolio approach. They describe what a fund possesses, without regard to how it might play with others. The alternatives style box, created by Morningstar's Jason Kephart, takes the relative view.

As Morningstar's style boxes are universal, rather than customized for each user, Jason needed to define the portfolio against which the alternative funds would be compared. He chose Morningstar's Global Markets Index--the world stock market. Most U.S. investors, of course, will own more domestic stocks than that index, and likely some bonds as well. However, as U.S. equities these days behave much like their overseas counterparts, and stocks typically drive a portfolio's results, the Global Markets Index should serve as a reasonably accurate proxy.

For Example
The chart below puts a picture to the words. It shows all funds in the long-short equity Morningstar Category that have a three-year track record (the period over which style boxes are calculated). The y-axis depicts the fund's correlation with the Global Markets Index. The maximum score is 1, and the minimum is negative 1. The x-axis illustrates the fund's relative volatility by dividing the standard deviation of its monthly returns by the standard deviation of the index. There is no maximum score (although in practice, it is usually less than 1). The minimum is 0.

For this column, I've added an additional feature (which might make a good permanent addition to Morningstar's graphics, if I say so myself). I have added the third dimension of total return to the style box's two existing dimensions of relative correlation and relative volatility. Funds that gained more than 5% annually during the trailing three years are colored green; those that appreciated less than 5% are gold; and those that lost money are, appropriately, in the red.

What to take from the graph?

For one, the dots lie to the northeast. The equity and fixed-income style boxes are neutral, in that no corner is better than another (the middle is also fine). Whether their placements are positive or negative depends upon the user's needs. The alternative-funds style box, on the other hand, carries an implicit preference. Funds that place to the upper right behave conventionally; they have correlations and volatilities that resemble those of the stock index. As funds move downwards and to the left, they become less mainstream.

In words, long-short equity funds aren't terribly "alternative." They tend to move in line with the world's equity markets, and recently they haven't been much less volatile, either. That should come as no surprise given how long-short equity funds are constructed. They start with the same foundation as traditional mutual funds--long equity positions--and then offset that exposure through short sales. For the most part, those shorts don't change a fund's basic characteristics. They dilute, but they do not alter.

Of the chart's 84 funds, four have negative correlations with the Morningstar Global Markets Index, and another 10 have positive correlations of less than 0.50. The remaining 70 have positive correlations of greater than 0.50, meaning that they perform more like the index than not. Most of the category's funds also have relative volatilities of more than 0.50, indicating that while they do offer a gentler ride than a pure-stock index, they aren't without bumps. These funds do carry risks of their own.

(Jason hastens to remind me that, with global stock-market volatility dropping to record lows in recent years, that long-short equity funds are at a disadvantage with this presentation. Should equity volatility increase to something approaching historic norms, the funds' relative-volatility numbers would likely decline, and they would appear to be more alternative.)

Shifting Colors
The second item of note is the return pattern. The colors aren't greatly clustered, but there is nonetheless a theme. The green dots are toward the northeast. Their volatilities range widely, but their correlations tend to be high, with only three falling below the 0.50 mark. The red dots are the opposite, occupying the four positions that are furthest to the northwest. (Somewhat curiously, they also claim four spots in the northeast.) The gold dots land somewhere in the middle.

This all makes sense. At a time when stock-market performance has been strong, as with the past three years, one would expect the alternative funds that aren't so alternative to post the highest returns. Conversely, those furthest from the mainstream would be struggling--because not much good has come from betting against equities lately. And the gold funds, possessing the halfway characteristics, have performed accordingly.

Heading forward, the dots' positions will be more stable than their colors. The funds' plotted styles won't change much. Long-short equity funds that hedge only modestly will continue to behave like watered-down but conventional equity funds, while those funds that place on the fringes of the style box figure to remain outliers. However, the relative performances of funds might well reverse. If global stocks take a tumble, the red funds will be far better bets than the green.

In summary, the alternatives style box should reliably indicate how well a fund diversifies a typical portfolio. This is a different portrayal of risk than is customarily given, and useful to possess. What the style box can't do, though, is serve as a guide to future returns. Those will depend upon the stock markets' behavior. 


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.