Introduction In 2018, we introduced a more robust approach to evaluating alternative funds' performance that considers diversification benefits they might confer to a traditional portfolio. In this article, we've updated the results of our previous study as of March 31, 2019, and included more granular results using Morningstar's institutional categories, which include sub-strategies within the multialternative and market neutral Morningstar Categories. Event-driven funds, a sub-strategy within market neutral, have done particularly well over the trailing three years.
- Very few liquid alternative funds would have made a more than 10% improvement to a simple 60/40 portfolio's risk-adjusted returns since 2012.
- Liquid alternative strategies designed to have little correlation to equities, like market neutral and managed-futures funds, have the highest rates of making a positive impact over the period.
- Over the past three years, event-driven funds had by far the best odds of improving a portfolio's risk-adjusted returns by more than 10%.
Using Modern Portfolio Theory to Help Benchmark Liquid Alternatives To understand how an alternative fund can improve a portfolio, investors need to consider the potential diversification benefits in addition to risk and return characteristics. Including the diversification benefit aligns with the basic concept of Modern Portfolio Theory. Modern portfolio theory holds that an investor should seek to maximize return for a given level of risk, defined as volatility, or minimize risk for the same unit of return. An investor can lower a portfolio's overall risk by adding strategies or asset classes that have a low correlation to the portfolio and are expected to deliver positive returns above cash over the long term.
Liquid alternatives have largely been marketed as a way to diversify a traditional portfolio of stocks and bonds. Using the Modern Portfolio Theory framework, we can test whether an alternative fund would improve a portfolio using a simple formula. Specifically, if an alternative fund's expected Sharpe ratio exceeds the portfolio's expected Sharpe ratio multiplied by the forecast correlation between the two, then adding the alternative to the allocation will improve its future risk-adjusted returns.
This equation shows that the lower an alternative fund's expected correlation to the existing baseline portfolio, the lower its future expected risk-adjusted returns could be while still improving the overall portfolio's risk-adjusted performance, and vice versa.
Putting Alternatives to the Test (Again) While we don't presume to forecast expected returns and covariances, we can apply this formula retrospectively to test whether alternative funds would have enhanced a hypothetical portfolio.
For the test, we used a hypothetical portfolio with the following allocations:
- 60% equity
- 45% U.S. Equity (S&P 500)
- 15% International Equity (MSCI EAFE Index)
- 40% Fixed Income
- 35% U.S. Investment-Grade (Bloomberg Barclays U.S. Aggregate Bond Index)
- 5% U.S. Non-Investment-Grade (Bloomberg U.S. High Yield 2% Issuer Cap Index)
We assumed the portfolio allocations were rebalanced back to the target monthly.
For the test, we looked at the period from the start of 2012 through March 31, 2019. (Too few alternatives funds existed prior to 2012 to form a reasonable sample size.) We also looked at the three-year period ended March 31, 2019 to zero in on more-recent performance trends.
One limitation of the formula is that it is binary: An alternative fund would have either improved the starting portfolio's efficiency, or not. In practice, one would want to know if the improvement (if any) was marginal or substantial. In order to be able to tell by how much the Sharpe ratio would have improved in the presence of an alternative fund addition to the baseline portfolio, one needs to know the weight of the alternative fund in the portfolio. We thus use an optimizer to calculate the alternative fund’s weight that would maximize the overall portfolio Sharpe ratio, and use this best-case scenario weight as the basis for calculating the level of potential improvement in the Sharpe ratio.
Exhibit 1 shows the number of funds in each category that would have failed to improve the portfolio’s risk-adjusted returns; the number that would have improved the risk-adjusted returns by 1% to 10% (small improvements); and those that would have improved by more than 10%, (a noticeable improvement).
Even under the best-case scenario found by the optimization process, most liquid alternatives would have failed to improve the starting portfolio since 2012. Only four of the 91 liquid alternative funds that existed for the full period would have improved our starting portfolio's risk-adjusted returns by more than 10%. A little less than one third would have made small improvements. These results exclude funds that began but didn't finish the period because they were merged or liquidated away in the interim. As such, the findings below are survivorship-biased. If we included the dead funds, the results would look notably worse. We covered the very high death rates for liquid alternative funds last year.
The market neutral and managed futures categories had the smallest percentage of funds fail to improve the portfolio. That’s not surprising, given that funds in both categories should be expected to have low correlations to stocks and bonds over long periods. Of course, we can’t emphasize the survivorship bias in these results enough. In market neutral, for example, 24 of the 39 funds that existed at the start of 2012, were liquidated or merged before the end of the period we looked at.
Using Morningstar’s institutional categories, we can take a more granular look into the market neutral and multialternative categories. Exhibit 2 shows the results of the sub-strategies in those categories.
Within the multialternative category, funds that build portfolios of multiple alternative strategies fared better than global macro funds, which take a more tactical approach to long-short investing across multiple asset classes.
Event-driven funds and equity market-neutral funds both fared OK. Only two equity market-neutral funds and three event-driven funds that survived the period failed to improve the portfolio.
Over the more-recent three-year period, liquid alternatives' performance has marginally improved, likely due to an increase in market volatility and more high-quality strategies being launched post-2012. For example, 19 of the 35 liquid alternative strategies that are Morningstar Medalists were launched after 2012. Exhibit 3 shows the results by Morningstar Category and Exhibit 4 shows the results by sub-strategy.
In total, 24 liquid alternative funds would have improved the portfolio's risk-adjusted returns by more than 10%. Most of those strategies were in the event-driven category. Earlier this year, Morningstar analyst Bobby Blue wrote about the opportunity set for event-driven funds and why rising interest rates have been a tailwind for the strategy.
It is still disappointing that nearly three fuorths of liquid alternative funds were not able to improve the portfolio’s risk-adjusted returns.
Conclusion Liquid alternative strategies have faced a challenging market environment over the past seven years, but there have been some bright spots. To increase the odds of choosing an alternative strategy that has a better chance of positively affecting a portfolio, investors should focus on strategies that they expect to have low correlations to traditional stocks and bonds and positive risk-adjusted returns over the long term.