Alternative mutual funds remain popular among investors. In 2013, U.S. alternative mutual funds took in $40.2 billion in inflows, compared to $13.4 billion in 2012, according to Morningstar. With so many alternative funds to choose from, advisors need to understand the basic differences between alternative investment vehicles—and how to properly evaluate them—in order to reap the highest potential rewards and understand the associated risks on behalf of their clients.
No investor would object to high returns from alternative investments, but a simple review of raw returns alone is not a sufficient measure of long-term success in alternative investing. The nature of alternative investments, and their complete associated set of objectives, should lead advisors and investors to consider other important criteria in their due diligence of alternative managers and products.
Absolute Return vs. Relative Return
Traditional mutual funds that attempt to generate better returns than the market, their competitors, or their categories often deploy a relative-return approach, typically defining success by a comparison to traditional market risks such as broad equity or fixed-income indices. By contrast, alternative mutual funds often seek an absolute-return and risk objective that is meant to be much less dependent on traditional market outcomes.
Historically, absolute-return approaches were deployed by hedge fund managers and only available to accredited investors in private structures. But more recently, these kinds of strategies have become available to a broad range of investors through the mutual fund structure.
Defining Success in an Absolute-Return Context
In order to best evaluate alternative mutual funds, it is important to more thoughtfully define the characteristics of investment success in alternatives. Success is not just about measuring raw returns. Specifically, in addition to returns, investors need to consider return efficiency relative to risk, the potential for downside risk protection, and the degree of correlation to traditional market risks. Taken together, these three additional measures provide a more complete scorecard for alternative investment outcomes.
Let’s examine each element separately. Investors can measure return efficiency by adjusting raw returns for the amount of return variability. Specifically, investors often use the Sharpe Ratio, developed by William Sharpe, which divides returns that are above the risk-free rate by the level of return volatility for a given period. This adjustment of returns has the added benefit of making investments with different absolute-return outcomes more comparable.
A good analogy for this approach might be the concept of fuel efficiency in cars. Consumers don’t consider a car with a larger gas tank to necessarily be superior to one with a smaller tank. “Miles per gallon” tells how efficiently each car uses fuel. Similarly, Sharpe ratios reflect the historical return efficiency of the asset. If an alternative mutual fund achieves higher returns but takes significant risk to achieve those returns, then the fund may not be a very efficient investment vehicle.
Alternative investments should seek a more efficient return profile. Alternative fund managers that obtain proportionately higher returns with less risk offer the chance to deliver investors a smoother ride and, ultimately, can provide them with more capital over the long term. If a fund manager takes a high amount of risk to achieve higher returns, he or she may incur the downside risk that comes with a two-sided market. Furthermore, it is even possible for funds that produce a slightly lower average return, but require a proportionately lower amount of risk to do so, to produce better long-term outcomes. Higher Sharpe ratios should be an explicit goal of alternative investing.
Investors should also evaluate the potential for downside risk protection. Said differently, alternative funds should seek an asymmetric return distribution—one in which returns are skewed more toward the upside than the downside. Avoiding large drawdowns, both as a general characteristic of the strategy and also relative to market environments where traditional market exposures suffer, should be another important objective of any alternative investment. Often, the source of this asymmetry lies in the investment flexibility of many alternative strategies—the ability to hedge with short positions, the ability to use derivatives, etc.—with the goal of ultimately delivering less risk for investors, just when they need it.
Finally, investors should evaluate alternative mutual funds for the ability to deliver a return stream that is truly different. The correlation to traditional market risks—the degree to which an investment moves in the same direction at the same time, or not—is the key to whether or not that investment will provide a diversification benefit to a traditional portfolio. We believe alternative funds should seek a return profile with a low correlation (less than 0.5) to those risks in order to maximize the potential diversification benefits.
To date, one of the notable areas of under-achievement for liquid alternative products in general has been the relatively high correlation to the S&P 500 Index which has been observed among much of the alternative investment industry offerings. Investors should not pay higher fees for a muted version of equity risk. We believe a large potential source of value for alternatives is their potential to be different. Investors should seek lower correlation investments precisely because this attribute will help protect their capital when traditional markets suffer.
The Next Step
When advisors and their clients decide to commit to an alternative-funds allocation, a strong understanding and evaluation of the full set of dimensions of alternative investment success will improve their chances for fully realizing the benefits of that allocation. More than that, finding managers who explicitly seek and can deliver a more efficient, asymmetric, and less-correlated return profile will likely provide a more satisfying investment experience by placing return outcomes in a more thoughtful context.
Finally, as investors and advisors consider a “first step” into alternative mutual funds, one approach may be to begin with a single fund that already comes fully diversified. Specifically, investors might want to consider an initial core allocation that incorporates multiple managers and multiple strategies into one fund. Multi-manager/multi-strategy funds that provide the right mix can deliver complementary strengths over time and can serve as a straightforward starting point for many investors.
Andrew Dudley, CFA is Senior Portfolio Manager at Context Asset Management , a provider of alternative mutual funds for retail and institutional clients.