Liquid Alts Funds That Weathered the Sell-Off Storm

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How did defensive liquid alternatives funds fare amid the recent market correction? Joining me to discuss that topic is Jason Kephart, he's a senior analyst in Morningstar's Manager Research Group.

Jason, thank you so much for being here.

Jason Kephart: Thanks for having me.

Benz: Jason, let's start by talking about the universe of liquid alternatives mutual funds. It's a broad basket, right? Not all of these funds are set up to be defensive.

Kephart: It's a very diverse category, and you definitely have different degrees of defense being played across categories. Long-short equity are going to have some net equity exposure, so when markets are down pretty reliably they're going to be down too, in general. Except for maybe some exceptions, but the two categories I think people think of as most defensive are managed futures and market neutral.

Benz: Let's talk about those categories. First, what they do, because I think they may not be so familiar to many investors. Then let's talk about this window that we had recently into equity market volatility, bonds not performing so well, either. Let's start with market neutral and talk about that category; what it does and how it fared recently.

Kephart: Market neutral funds are basically long- and short-stocks in equal amounts. What you're doing is basically eliminating any equity market exposure. They shouldn't really be driven by directions in the broad market. If the S&P is up or down, that shouldn't really drive the performance of the market neutral fund. What's going to drive it is the stock-picking skills of the manager. If their longs are outperforming their shorts, when markets are going up or down, then they're going to be profitable and vice versa.

Benz: During this period of equity market volatility, the very recent period, how did the funds do?

Kephart: They held up pretty well. The category average was down about 1%. There's two distinct substrategies within market neutral. You have the equity market neutral, where managers are picking stocks based on fundamental characteristics or risk premia. Then you also have merger arbitrage strategies, which are basically betting on announced mergers and acquisitions. The merger funds held up very well, because even though there was a lot of volatility in the stock market, deal spreads didn't really widen that much.

Benz: Define deal spreads before we go further.

Kephart: The deal spread is when a company announces they're going to acquire another company, typically the company that's being acquired won't go exactly to the closing price; there will be some kind of a spread between the announced price and where the company trades at. The bigger the risk of the deal not going through, that's going to reflect in the deal.

Benz: So it will be wider.

Kephart: Yeah, the deal spread.

Benz: Those strategies did really well, so funds like Merger Fund, for example, held its ground.

Kephart: Yeah, Merger Fund, Arbitrage Fund, they were both down about, I think, a little bit less than 1%. Compared to the Vanguard Total Bond Market ETF, they held up a little bit better. They did provide that downside protection you're looking for from an alternative strategy.

Benz: Let's take a look at managed futures. First, let's talk about what those funds are set up to do.

Kephart: Managed futures funds are trend followers, and they can go long or short across multiple asset classes, typically equities, interest rates, commodities, currencies, and they're going to follow the trends wherever they lead them. They're not trying to predict, which ways the markets are going to go. So in a period, like we just had, where the correction was a quick reversal of a lot of long-term trends that we had seen in equity markets going up, recently commodities had been on the upswing, particularly, oil. In the correction, you saw all of these trends quickly reverse, and that's kind of the recipe for disaster for these kinds of strategies.

Benz: When you look at performance among this subset of managed futures funds, not so hot during the recent sell-off?

Kephart: They also are very volatile strategies. The average fund, it has a target volatility of about 10%, which is about two thirds of what the equity market's been historically, although it's pretty high compared to recent volatility levels. On average, the managed futures funds lost about 7% or 8%, which, given that stocks were down about 10% over the period, it's not a disastrous scenario, but it definitely wasn't the kind of crisis alpha that managed futures funds, I think, had been known for. In the tech bubble and in the financial crisis, they performed very strongly and were up quite a bit, while everything else was down, but in this period, they got whipsawed along with everyone else.

Benz: If they're trend chasers, or trend followers, it seems like there's a lot of opportunity for them to do very different things, to be following different trends. Did you see a big gulf, in terms of best to worst performers during this recent period?

Kephart: No, it was everyone kind of fell together. Because, I think, most of them were all long-equities because the trend in equities had been so strong.

Benz: For so long.

Kephart: For so long, and, also, we had seen interest rates creeping up, so they were short interest rates too, most likely. When interest rates, even though bonds didn't do that well, interest rates held up pretty well, so that didn't really help them either. And commodities fell, so it was kind of just everyone suffered a lot.

Benz: You referenced that the managed futures funds have actually done alright when stressed tested in previous crises. Can we step back and look at the more defensive liquid alts? When you take the long view and, of course, the funds, on average, have not been around that long, but can you talk about how they've performed in previous periods of equity market weakness?

Kephart: Most liquid alt funds, I think, only half the funds that are around today have even a three-year track record. We've only had really these small little corrections to really judge how they're going to do. Managed futures, in general, though in the hedge fund world, do have a longer track record. They did very well in 2008 and in 2000. The difference between their bear market performance and these short-term corrections is really the speed and how quickly the markets are falling. In 2008, the market peaked in October 2007, and so you had this long downward trend that accelerated in the fall of 2008. The trend was always going the same direction. Then when the magnitude really increased, they benefited from it. What they're not going to do well is these short-term reversals. They're not going to protect against corrections, probably, if they're very sharp in nature.

Benz: I guess, my question is, if someone has a well-diversified portfolio, meaning that they have high-quality bonds, they have stocks, maybe they have a cash allocation for near term needs. Do these funds serve a role in a portfolio at all?

Kephart: They're definitely not right for everyone. They're not a must-have for every portfolio, but I think they are a useful tool to more diversify a portfolio. For the most part, you should be looking at them as an equity substitute, because even though market neutral is not going to be driven by the direction of the equity market, they don't have the safety net of bonds. Even if bonds are doing poorly, they're going to be down 1%, 2%, maybe. Equity market neutral funds could go either way. That's a risk that, I think, you really want to keep in mind. You don't want to add more downside risk to a portfolio.

Benz: With managed futures, should I also be thinking of that as maybe an equity substitute?

Kephart: Absolutely, an equity substitute because it's quite volatile, and you could have very big swings in performance, both for the upside and downside. You want that to take the place of some risk assets.

Benz: Last question for you Jason is, the liquidity, the liquid alts funds, the idea there is that you'll be able to come and go as you want. Is there, potentially, a mismatch with the types of assets that they own, or do funds try to control for that issue?

Kephart: Funds tend to control for that. Managed futures are trading only futures contracts, which tend to be very liquid and they're sticking to very major markets. Liquidity is not really an issue in those funds. Equity market neutral funds are going to be trading equities, which, again, tend to be very liquid. They don't go very small down the size ladder. Where you'd be worried is more in the credit area, and we've mainly seen funds steer on the side of caution when it comes to it.

Benz: Overall takeaways though is, keep my position size relatively small if I go at all, and use this to supplant equity market exposure versus some sort of bond exposure that I might otherwise take away from.

Kephart: Yeah, and you really want to judge them over a full market cycle. These corrections are good stress tests to make sure things are within reason, within expectations, but you wouldn't want to extrapolate too much from any short-term period.

Benz: OK, Jason. Thank you so much for being here.

Kephart: Thank you for having me.

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