Alternative Funds Are in a Time Warp

The gravitational forces that drive the rest of the mutual fund market—toward lower fees, more transparency, and better investor outcomes— seem not to apply to the alternatives part of the fund world. Despite much innovation and the emergence of credible new players, the alternative space looks more like the fund world of yore than the investor-focused fund world of today. In short, while the fund market as a whole has become a place driven by the demands of buyers, the alternatives space remains a seller’s market.

Four things must change to turn the odds more in investors’ favor and make alternatives a part of the mainstream fund world. First, fees must come down. The reality distortion field that has allowed alternative investors to charge higher fees despite their lower returns simply cannot last. How much longer will advisors who purge traditional active managers for the cost savings of index funds tolerate the inflated fees of alternatives, especially as the disappointing returns of many of these funds continue to accrue? The same math applies to all investments. If high fees undermine the attractiveness of active managers, higher fees must do even more to undermine the allure of alternative managers. The expectations of miraculous performances will diminish as disappointing investor experiences accumulate. Low costs cannot remain a factor that is worshiped in most of the portfolio, but ignored in another part. Vanguard’s continued experimentation with alternatives (one imagines to Jack Bogle’s horror) may prove a catalyst for this inevitable change.

Second, guidance on how to deploy alternatives must improve. Too many ill-defined activities occur under the alternatives banner. As such, it’s very difficult for investors or their advisors to set appropriate expectations for the alternatives they consider. It’s not dissimilar to the fund world of 30 years ago where you had to be an inside player to know that Vanguard Windsor VWNDX was a value fund and Janus a growth fund, that Templeton Growth TEPLX scoured the globe for investments, but Fidelity Magellan FMAGX, despite its globe-spanning name, focused just on the United States.

Today, many investors buy alternatives as a form of insurance against a market correction without realizing that many alternatives are highly correlated with the market. It’s like buying insurance but not knowing if you’re insuring your house, your life, or your car. Such misalignments must be addressed if investors are to use these funds successfully. The new Morningstar Style Box for alternatives funds may make a contribution toward better deployment of alternative funds. Fund companies can also help by setting clearer expectations for their funds and by demonstrating how these funds can be properly deployed in their own fund-of-funds offerings like target-date funds. Until alternative funds are deployed better, they will do more to damage the industry’s reputation than to enhance it.

Third, trusted traditional players must join the party. Innovation always starts from the edges, and each major innovation provides an opportunity for new players to rise. Yet ultimately, the established players must follow suit if the trend is to go mainstream. T. Rowe Price may have been a small-cap pioneer, but it was older firms following suit that made small-cap a part of the investor tool kit. The same was true for Templeton’s forays into international stocks. While innovators spur change, it is the competition from established players that marks the maturation of the trend. To date, investors have benefited from quality firms such as AQR entering the business and opening up new channels in the alternative space, but it is the endorsement of firms such as Vanguard and Fidelity that will stamp alternatives as part of the investment mainstream.

Finally—and most importantly—alternatives must generate real-world success stories that advisors and investors can point to in order to justify their faith in the category. To date, these have been few and far between. Investors ignored alternative strategies before the financial crisis of 2007–08, but then flocked to them in its aftermath, buying what they wish they had bought two years earlier. Over the ensuing decade, those enthusiasts have seen paltry returns from their alternative choices relative to the outsized gains won in broad market indexes and in traditional active funds. Therein lies the core difficulty of alternatives. In bull markets, investors focus on relative returns. It is only after losses that their attention shifts to absolute performance. If an investment attracts money when it is entering a period of relative underperformance, but loses that money before it can generate superior absolute returns, it does investors no favors.

Ultimately, it is the investor experiences that are generated that determine the true success of an investment. To date, index funds have created good investor outcomes; alternatives have not. Hence, indexing has gained greater general acceptance. Figuring out how to generate better investor outcomes is the key to the eventual adoption of alternatives into the investor tool kit.

It remains to be seen whether alternatives will earn investor loyalty or if the category will be another in a long string of black eyes for the financial-services industry. The potential to better investor outcomes seems to be there. Indeed, the interest expressed in the category by credible players such as Vanguard and PIMCO plus the credibility of new players such as AQR and Research Affiliates bodes well for the possibilities of the category. To date, however, the alternatives market still looks too much like the flawed mutual fund marketplace of the 1980s, a time when funds were sold and not bought, than it resembles today’s modern, investor-centric fund world. Time will tell if alternatives can break out of this time warp and make a credible contribution to investors’ success and the industry’s future.

This article originally appeared in the February/March 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.