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Liquid Alts Face Headwinds in Strong Stock Market: Study

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A new study released by Morningstar had some disturbing findings for purveyors of liquid alternatives. The study was done to determine whether alternative mutual funds added value to a portfolio beyond absolute returns, and instead focused on diversification added to a portfolio and correlation to stocks and bonds.

Some key takeaways from the study were:

  • Few alternative mutual funds have “conferred meaningful diversification benefits in recent years.”
  • The past five years has been one of the worst periods for alternative strategies since 1983.
  • Alternative strategies have increasingly been correlated to stocks and bonds; further, the 60% stock, 40% bond traditional portfolio “has been tough to beat.”

Morningstar authors Jason Kephart, senior analyst, alternative strategies, and Maciej Kowara, senior analyst, fixed income strategies, determined to use modern portfolio theory as a base, and building on it, evaluated an alternative fund’s potential “by assessing whether it will improve a portfolio’s future risk-adjusted return,” focusing on the Sharpe ratio.

(Related: What Advisors Should Know About Liquid Alts)

Comparing alternative mutual funds to a traditional 60/40 portfolio, and focusing on 3- and 5- year periods ending December 2017, the results “were disappointing across both time periods,” the researchers found. “Over the trailing five years … not a single long-short equity fund would have improved our portfolio’s efficiency by at least 10%. Market-neutral funds fared better given their very low correlations to traditional equity and fixed income returns, as did managed futures funds.”

The researchers also found that hedge fund returns “have gotten increasingly correlated with the broader market’s returns over time,” which indicates they’ve been driven largely by stock and bond returns.

This increasing correlation with stocks and bonds, as well as the “standout” stock and bond market returns, have hurt the liquid alternatives market, the researchers concluded. The hot stock market may “prove temporary,” but the rising correlation to stocks and bonds issue “probably reflect structural changes, raising questions about whether nontraditional strategies con confer the same diversification benefits in the future as they did in the past.” Bottom line: Check how diversified the alternative is to the traditional portfolio.

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