The Pros & Cons of Alternative Mutual Funds

Analysts debate their short-term underperformance vs. longer-term potential

It’s been a good stretch for the broad U.S. equity market, despite the ongoing problems in Europe and the U.S. government’s fiscal woes.

The S&P 500 produced a 16% total return in 2012; the three-year average annualized return through year-end 2012 was 10.87%, and the index hit a five-year high in 2013’s early trading sessions.

The past year wasn’t so great for many alternative-asset mutual funds. As the figures in first table show, each of the seven fund categories, which include roughly 360 funds tracked by Morningstar, underperformed the S&P 500.

While it’s not surprising that bear-market funds underperformed, the other categories showed a wide range of performance results.

The average return for managed futures funds is “problematic,” said Mallory Horejs (left), a Morningstar fund analyst in Chicago, in an interview. “We’ve seen [that] over the longer run, the historical track record of this kind of trend-following strategy in hedge funds has done really well, and it’s provided great diversification. But the entrance into mutual funds has not been very good.”

The first mutual funds focused on the hedge-fund strategies emerged in 2008, and it’s been “a pretty choppy few years for them so far,” noted Horejs.

TABLE I

Morningstar Category Averages

Annual Return 2012 (%)

Currency

3.34

Market Neutral

0.18

Multi-Alternative

3.87

Managed Futures

-7.39

Long/Short Equity

5.15

Bear Market

-23.70

Non-Traditional Bond

7.5

S&P 500 Total Return

16.00

Barclays Global Aggregate Total Return

4.32

(Source: Morningstar)

The average return for managed-futures funds is “problematic,” said Mallory Horejs, a Morningstar fund analyst in Chicago, in an interview. “We’ve seen [that] over the longer run, the historical track record of this kind of trend-following strategy in hedge funds has done really well, and it’s provided great diversification. But the entrance into mutual funds has not been very good.”

The first mutual funds focused on the hedge-fund strategies emerged in 2008, and it’s been “a pretty choppy few years for them so far,” noted Horejs.

“They lost a ton of money last year, and their risk-adjusted returns are negative over the three- and five-year periods. That’s particularly troubling for investors, because I think of all the strategies, that one has the most true diversification potential,” the analyst said. “Its correlation is very, very low [with equities. But it’s certainly not going to be adding any value if the performance is negative.”

Despite the weak performance, though, Table 2 shows that managed futures and five of the other alternative categories still managed to attract investor funds through Nov. 30, 2012.

TABLE II

Morningstar Category

Total Net Assets ($)

2012 Year-to-date Flows ($)

Bear Market

6,266,316,372

2,851,164,139

Currency

11,358,105,849

58,933,150

Long/Short Equity

24,993,797,127

5,420,485,637

Managed Futures

8,574,369,933

912,558,999

Market Neutral

18,605,949,833

-257,688,954

Multi-Alternative

17,738,302,882

4,105,384,227

Non-Traditional Bond

58,524,214,153

3,386,402,336

All Alternative Mutual Funds

146,061,056,149

16,477,239,534

(Source: Morningstar)

Horejs recommends investors use caution when it comes to relying on a fund category’s average return, because the underlying funds’ performances can vary widely.

For instance, she says, some funds in the long/short equity category have very long exposure to the market, while others are closer to a market-neutral position. Among multi-alternative funds, some try to replicate hedge fund or other indexes, while other funds pursue a “go anywhere” strategy.

The long/short equity category has 72 funds that were tracked throughout 2012.

Horejs says the category’s top-performing fund for last year was Royce Opportunity Select (ROSFX). While that fund returned 35 percent, the lowest-returning long/short fund lost nearly 17 percent over the same period.

Most of the category’s top performers had very high equity exposure for the year, says Horejs. More conservative funds with less equity exposure are “really struggling in environments like last year’s,” she added.

Another potential problem: Many of the funds have short performance records. Almost 60% of the alternative-strategy funds Morningstar tracks launched after 2008.

To help investors and advisors identify the funds that are most likely to achieve their advertised diversification and risk-reward profiles, Morningstar recently started recognizing the top performing funds. More information on the award nominees in the alternatives category is available at Morningstar's website

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