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Rekenthaler Report

The Past Decade's Worst Alternative Investments

Some might succeed going forward, but not all.

Judgment Day
Retail alternative-investment funds, practically speaking, are 10 years old. Alternatives have long been in institutional portfolios, but they attracted little attention from retail buyers before the 2008 financial crash. After the disaster, however, the people craved protection, and the fund companies responded. Launching a spate of alternatives funds, they marketed the strategy hard.

The results, so far, have not been good. The problem is not just that the insurance was sold after the fire--a customary practice in investment management--but also that many of the alternatives have been flat-out losers. Even if U.S. stocks hadn't compounded by 13% annually during the decade of 2009 through 2018, those funds would have been poor choices.

Following are the five poorest alternative Morningstar Categories since 2009. For each category, I provide the trailing 10-year average annualized return, along with the number of times that the category beat the S&P 500 during the index's three weakest calendar years. (Scant gains in 2011 and 2015, and then a 4.4% loss during 2018.)

5) Multicurrency
Annualized return: 0%; 
1 for 3 against the S&P 500
There are three flavors of currency funds. Leveraged currency funds are for speculation. Single-currency funds are unleveraged and serve as substitutes for the foreign-exchange markets. Multicurrency funds are also unleveraged. Being more stable than single-currency funds, they are relatively painless devices for diversifying away from U.S. stock (and bond) market risk.

Unfortunately, they have also been profitless. Multicurrency funds delivered on their hope of low volatility. Over the decade, the category's worst calendar-year loss was just over 3%. Alas, the same was true of its best calendar-year gain. Multicurrency funds didn't lose much money, but they didn't make any either. Might as well have stashed your cash under a mattress.

Their performance, at least in nominal terms, will improve when global interest rates rise. Whether they will turn a profit after inflation is less certain. One thing is for sure: With such low expected total returns, multicurrency funds had better be cheap. Even more than most, these funds cannot overcome steep expenses.

4) Market Neutral
Annualized return: 0%; 1 for 3 against the S&P 500
If you swapped the calendar-year returns for the market-neutral category with those of multicurrency funds, nobody would know the difference. As with the multicurrency group, market-neutral funds gently fluctuated around a mean of zero. (Perhaps they should be called "return-neutral" funds.) So gently that the category never gained nor lost as much as 3% in any year. One needs to pinch the funds to ensure that they are alive.

Although the performance was identical to multicurrency funds, I placed the market-neutral category one notch lower because, unlike with the aforementioned group, I see no hope for market-neutral funds. Multicurrency funds can fare well if global fixed-income thrives, or if the U.S. dollar suffers. The expected return for market-neutral funds, on the other hand, is perpetually the Treasury bill rate, minus fund expenses. That is the category's math, and it is not a pleasant equation.

3) Managed Futures
Annualized return: negative 1.6%; 0 for 3 against the S&P 500
What a disappointment. Managed-futures funds were the 2008 success, notching a 5% gain even as all stock funds, all lower-credit bond funds, and even many alternatives funds cratered. (The average hedge fund, for example, dropped 18% for the year.) The reason cited was that their performance was not related to their underlying holdings. It matters not if they held stock, bond, currency, or commodities futures, nor if those contracts rose or fell. Managed-futures funds profit from anticipating price movements.

The story sounded convincing, particularly when accompanied by that 2008 gain. It no longer carries much credence. Not only have managed-futures funds fared badly overall, losing money for the decade, but when they were most needed, they shirked the cause. They declined during the S&P 500's two drab years, then dropped even more than the index in 2018. They didn't prevent the fire; they stoked it.

They may behave better during the next downturn. The strength of managed-futures funds is that they are truly unpredictable. Their positions change with the trends, as do their relative and absolute performances. Against that must be weighed the reality that, in aggregate and after their funds' expenses have been paid, the group's portfolio managers have been dart-throwing monkeys. Sometimes up, sometimes down, eventually landing (before costs) somewhere near zero.

2) Energy
Annualized return: 0.5% for equity energy, negative 9.1% for commodities energy; 0 for 3 against the S&P 500
Energy funds come in two varieties. One breed consists of traditional mutual funds, which invest in energy-related equities; Morningstar calls them "equity energy" funds. The other consists of exchange-traded funds, which primarily hold energy futures. They are entitled "commodities energy." Both types of funds move with oil prices, but not in lock step. Thus, equity energy funds eked out a small gain for the decade, while commodities energy ETFs got clocked with an annualized 9.1% loss.

Regrettably, energy funds were reliably awful when equities faltered. Rather than being alternatives, they were something of a super equity, performing best during the stock market rebound years of 2009 and 2016 and among the worst in 2015 and 2018. In no way, shape, or form were energy investments, either as equities or as futures contracts, effective hedges for stock portfolios.

They failed because inflation remained dormant. Consequently, oil prices primarily were affected by industrial production--which, unsurprisingly, also strongly affected stock quotes. Energy became just another stock market surrogate. That will likely hold until inflation once again becomes a global concern.

1) Bear Market
Annualized return: negative 18.9%; 1 for 3 against the S&P 500
This is a bit of a cheat, because there are few bear-market funds, and they have hardly any assets. But it's a amusing cheat, and Morningstar continues to support the category, so why not?

The bear-market category contains actively managed mutual funds that short stocks, as opposed to indexed (and often leveraged) ETFs, which are placed into Morningstar's "trading" categories. Their managers purportedly can identify overpriced securities, thereby permitting their funds to soar when stocks weaken and giving them a fighting chance at posting profits during flat markets.

That has not, shall we say, occurred. The bear-market category suffered double-digit losses for the decade's first six years, improved to a 4% drop in 2015, promptly got whacked during the next two years, and recorded a profit in its final attempt, in 2018. Its average annualized return is negative 18.9%, which happily does not lead to a 189% cumulative decline, thanks to the wonders of compounding. It would, however, have left the January 2009 investor with $0.12 on the dollar.

Things look up on Friday: the past decade's five best alternative investments.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com 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.