2014's Most Compelling Alternatives Performances

While the core U.S. stock and bond markets produced solid gains in 2014--6% for the Barclays U.S. Aggregate Bond Index and nearly 14% for the S&P 500--returns in Morningstar's alternatives mutual fund categories were, for the most part, decidedly more muted. That's to be expected: Most managers in these groups used hedged or uncorrelated strategies, so marching in lock step with benchmark indexes is not usually part of the plan.

That doesn't mean the year was lacking in excitement, however. So I'd like to highlight what I consider three of the most compelling stories pertaining to alternatives performance trends in 2014. In the spirit of the upcoming Academy Awards (and at the risk of having my poetic license revoked), I've tethered each of these Oscar-worthy performances to an Oscar-contending film. Keep in mind that great performances aren't always uplifting--recall that Anthony Hopkins won Best Actor for playing Hannibal Lecter. There weren't too many 2014 alts performances quite that terrifying, but investors in some strategies definitely had a bumpy ride.

Whiplash (or, What's the Matter With Long-Short Equity?) Like the young drum prodigy whipped around by his demanding, possibly psychopathic teacher in Whiplash, many investors in long-short equity funds were likely asking how they ended up bloodied and bruised in 2014. After a more-than respectable 2013--during which the average long-short equity fund returned 14.6%, about in line with the Morningstar Category's 0.5 beta to the S&P 500--the category came up limping in 2014. The average long-short fund returned a paltry 2.92%, only about one fifth the return of the S&P 500 (or well short of what one might expect based on the category beta).

There are some explanations for this gap, however. Perhaps most notably, the comparison with the S&P 500 is inapt for a year in which large-cap U.S. equities vastly outperformed both small-cap domestic stocks and international equities (the Russell 2000 rose only 5%, while the MSCI EAFE lost 5%). The long-short equity category has significantly more exposure to both small caps and foreign stocks than the S&P 500. When matched up to the Russell 3000 Equal Weight Index (which provides a broader-cap representation of the U.S. market), which gained 5.45% in 2014, the long-short category's returns seem more reasonable.

Diverse approaches abound in the category, and thus there's a wide dispersion of results. Many long-short funds did quite well in 2014. Top performers in the category, such as Highland Long/Short Healthcare HHCAX and AQR Long-Short Equity QLENX, returned 14% or higher. Two of Morningstar's Alternatives Fund Manager of the Year candidates,

Still, plenty of funds experienced losses--not a desirable outcome when markets are up. It's one thing to lag a bull market and quite another to plunge into the red. And perhaps the biggest whiplash of all was inflicted on investors in

Wild (or, the Re-Emergence of Managed Futures) In Wild, based on the memoir by Cheryl Strayed, the main character (played by Reese Witherspoon) goes on a solo journey through the wilderness of the Pacific Crest Trail to discover a better version of herself. Investors in managed futures have been on a similar trek through the wilderness in recent years, enduring the deprivation and humiliation of paltry (and often negative) returns since 2009, even as equity markets skyrocketed upward. Many of those investors piled into managed futures after their superb performance during the crash of 2008, undoubtedly expecting more of the same. Fingers have been pointed at various culprits: central-bank interventions, muted volatility, the lack of sustainable trends for these momentum-oriented vehicles to latch on to, and the low-interest-rate environment.

But 2014 was an oasis in the desert for thirsty managed-futures travelers. The managed-futures category was the best-performing of any alternatives category, with an average 9.07% return for the year. Strong, sustainable trends in several asset classes--notably, the downward pressure in commodity prices and the strength of the dollar relative to other currencies--aided these trend-following funds, which can go long or short the various asset classes.

Because managers in the category target a range of volatility levels, some of the more aggressive funds reached unusually high returns--the top five funds in the category all returned in excess of 20%. Morningstar's lone Medalist in the category, Silver-rated

American Sniper (or, the Dominance of the U.S. Dollar) Within Morningstar's multicurrency category, one magnetic and powerful icon of America shot down all others in 2014: the U.S. dollar. While major currencies across the globe faced challenges--from central-bank stimulus in Japan, to economic struggles and European Central Bank easing in the eurozone, to commodity-export weakness in the Australian and Canadian markets--the U.S. economy continued to find solid footing as one of the few sources of growth worldwide. The Fed's reaffirmed goal of raising interest rates later in 2015 is a further bullish sign for the U.S. dollar.

Most multicurrency funds, however, came out on the wrong end of this equation. That's because most strategies in the category are short the U.S. dollar, intended to diversify the U.S. dollar risk that an investor carries in a typical portfolio. As a result, the category as whole lost 1.64% on average in 2014. Contributing to the poor performance were large positions in the euro (which constitutes the biggest component of the inverse U.S. dollar index, a typical benchmark for these funds) and the Canadian dollar (which was hurt in the oil-export currency sell-off). So-called hard-currency funds, like Silver-rated

Macro trends will always play a major role in the performance of currency funds. Plenty of experts think the U.S. dollar will eventually be forced to pay the piper for the Fed's massive balance sheet. But in the near term, the U.S. remains the global markets' "cleanest dirty shirt" (in the words of Bill Gross), and dollar strength is likely to continue.