7 Liquid Alternatives for a Bear Market

Advisors and investors looking for bear-market performance should look at how liquid alternatives fared during some recent pullbacks

The number of liquid alternative-investment mutual funds and exchange traded products continues to grow. According to Morningstar analyst Michael Coop, mutual -fund companies have launched an average of four new products each month in these categories over the past five years: Investors are noticing: Alternative mutual funds held $122 billion at year-end 2011, the culmination of five consecutive years of inflows, Morningstar estimates.

Although U.S.-equity mutual funds still held more assets with $260 billion, these more-traditional funds had experienced five consecutive years of outflows.

After a strong run-up in the first four months of 2012, U.S. equity markets started to drop in May, which conceivably could lead to greater interest in liquid alternatives. Before jumping in, advisors and investors looking for liquid alternatives that offer bear-market performance may want to look at how the various liquid alternative categories performed during some recent pullbacks.

To track such performance, Morningstar uses seven different classifications for liquid alternatives: bear market; currency; long/short equity; managed futures; market neutral; multi-alternative and nontraditional bond, explains Mallory Horejs (left), an alternative-investments analyst with the Chicago-based research and ratings firm.

Each category has a unique risk/reward profile, Horejs notes, and bear-market funds provide the purest downside play. “I think almost all the funds in this category are just pure inverse index products,” she said in an interview with AdvisorOne. “So, they’re certainly the top performer during different periods of financial distress.

Last year, when the market fell about 17% from April to October, these funds were up 20%, “because they’re just providing the inverse of the index,” Horejs notes. Among the other categories, currency and market-neutral have been the best for downside protection, the analyst adds, which reflects the underlying portfolios.

Month-end data through May 31 from Morningstar illustrates how the alternative categories differ in terms of annual returns and during the most recent market downturns:

Liquid Alternative Funds Annual Returns, Annualized

Category

Total Return YTD %

(S&P 500 = 5.16)

Total Return 3 Yr %

(S&P 500 = 14.92)

Total Return 5 Yr %

(S&P 500 = -0.92)

Bear Market

-8.10

-26.11

 -13.50

Currencies

-0.63

   0.58

   0.41

Long/Short Equity

 0.55

   5.00

  -1.51

Managed Futures

-0.98

  -5.02

  -1.37

Market Neutral

-0.07

   0.51

  -0.09

Multi-alternatives

-0.49

   3.68

  -1.39

Non-traditional bond

2.61

   6.17

   3.23

Category

Financial Crisis %* 

(S&P 500 = -54.89)

Flash Crash %*

(S&P = -15.63)

'11 Drawdown %*

(S&P 500 = -16.89)

Bear Market

 90.60

 17.33

 20.46

Currencies

 -0.83

 -0.67

 -5.52

Long/Short Equity

-24.58

 -5.54

-11.12

Managed Futures 

 20.54

 -4.68

 -5.08

Market Neutral

 -1.92

 -0.28

 -1.48

Multi-alternatives

-28.65

 -6.19

 -6.32

Non-traditional bond

-15.24

 -0.75

 -2.63

 * Crisis, 10/9/7-3/9/9; Flash Crash, 4/26/10-7/5/10; '11 Drawdown, 4/26/11-10/3/11.

Before investors consider a new fund offering, though, Horejs recommends they review the manager’s experience with alternative strategies.

“More recently we’ve seen traditional shops rushing to get into the space, too, and offering alternative strategies that are maybe being run by managers that don’t have any experience and that’s a big red flag,” she says. “Shorting experience is definitely something that investors should be looking for whether it’s through a hedge fund or a similar mutual fund or there’s some sort of institutional experience, it’s definitely something investors should look for.”

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