Rules for Alternatives

Alternative funds have been one of the fastest-growing segments of the mutual fund industry in recent years. “Alt funds,” as they are commonly referred to, seek to provide attractive absolute and relative long-term returns, typically with lower risk than stock funds. They can offer diversification to traditional stock and bond portfolios.

When one considers the current rock-bottom bond yields, high stock valuations and the market’s recent volatility, it’s not difficult to understand alt funds’ appeal.

But some alternative mutual funds have fallen short. Their proliferation has increased the choices, making the research process even more important in selecting a solid fund for your clients.

For over a decade, our firm has invested in alternative strategies, including alternative mutual funds, for our clients. We have reviewed scores of these funds over that time period. Here are 10 rules to consider when researching them:

1. Begin With The End In Mind.

There are many varieties of alternative investment. The first step in evaluating an alternative mutual fund is determining what you are trying to accomplish. What level of risk, return and correlation to stock and bond markets are you looking for? Are you looking for a low-risk bond surrogate, a more growth-oriented (and thus riskier) strategy, or something in between? If you are adding alternatives to a traditional stock and bond portfolio, what asset classes are you reducing to make room for the new strategy? Knowing may help you determine the characteristics of the alternative investment you’re looking for. Alternative investment strategies sometimes promise to deliver “stock-like returns with bond-like risk,” but things that sound too good to be true usually are.

2. Don’t Skip The Basics.

Your research on alternative investments should include all of the due diligence you would normally conduct on traditional investment managers. That means evaluating a manager’s “four P’s”: its people, process, philosophy and performance. Quantitative data such as performance is available in mutual fund databases. The management firm’s investment presentation, shareholder reports and commentaries from recent years should offer insight on its people, investment process and philosophy. After you read these documents, a phone interview with the portfolio manager can help you understand his or her thinking. Finally, face time with key members of the investment team during on-site visits will be very useful in helping you assess the qualitative aspects of the manager.

3. More Complicated Strategies Take More Time To Research.

Alternative mutual funds are often more complicated than traditional stock and bond mutual funds. As fiduciaries, we are responsible for thoroughly investigating and researching the investments we recommend to our clients. For example, we followed managed futures strategies for years before investing in a fund for our clients. We wanted to take extra time to really understand how the investment worked. It should go without saying, but if you don’t have a good understanding of a strategy, you shouldn’t recommend it to your clients.

4. Ask What Could Go Wrong.

Risk is often thought of as volatility or the standard deviation of returns. When evaluating alternative investments, advisors should seek to gain a deeper understanding of the risks the strategy is taking and what could go wrong. We want to uncover hidden risks that may not show up in the investments’ historical standard deviation. The risk section of a fund’s prospectus can provide you with clues for investigating the risk of a strategy. For example, does the strategy employ leverage, use derivatives, invest in illiquid securities or use counterparties? What are the risks related to each? Other questions we often ask: What is a perfect storm for this strategy? How much could the strategy lose in that scenario? What risks does the portfolio manager believe are the most significant? In which environments is the strategy expected to do well—and in which will it likely do poorly?

5. Compare Apples To Apples.

It would be silly to compare a small-cap value fund with an emerging markets equity fund or compare a high-yield bond fund with a municipal bond fund. So it’s important to remember that alternatives also cover a wide range of similarly diverse strategies. Morningstar currently breaks the alternative universe into more than a dozen categories including long/short equity, bear market funds and market neutral funds. When researching alt funds, it’s important to compare those that follow similar strategies. Even within categories, the strategies can vary greatly in their approach.

6. Past Performance Is No Guarantee, But Still Nice To Have.

Past performance is no guarantee of future returns, but it is helpful to see how a fund has performed in the past. Because so many alternative mutual funds have come out in recent years, many don’t have a five-year or even a three-year track record. Some funds with shorter track records offer historical performance from either a similar institutional strategy or back-tested data. But a strategy in a mutual fund may be very different from an institutional strategy because there are limits on illiquid investments, limits on leverage and diversification requirements, to name just a few potential differences. It’s important to understand the differences before you can determine whether the institutional track record is applicable to the fund strategy. Also, it is good to confirm that the performance data is actual live data and not back-tested data. Back-tested data always looks good! If the institutional strategy is very similar to the fund’s, you can be comfortable analyzing it.

7. Consider Market Cycle Performance In Standard Time Periods.

In addition to looking at performance over the standard one-, three- and five-year time periods, it is important, especially with alternative strategies, to review how funds perform during different parts of the market cycle. We like to review performance from the peak of the market to the trough, from the trough to the peak, and over the full market cycle. Standard one-, three- and five-year time frames may all take place during a bull market, giving you only half the story.

8. Consider Risk-Adjusted Performance.

Within alternatives, more so than in traditional stocks and bonds, strategies may be run with more or less risk, and you need to account for that when comparing strategies. For example, one long/short equity strategy may typically be 40% net long and another 20%. Using risk-adjusted performance measures such as the Sharpe ratio is helpful when comparing managers with different risk characteristics.

9. Consider The Correlation To Stock And Bond Markets.

Part of the appeal of alternative investments is the diversification they offer apart from traditional stock and bond markets. But it’s important to consider how correlated each alternative investment is to those markets and how much diversification it will provide to the portfolio. Those correlations may change over time as well. For example, managed futures strategies may have a positive correlation to stocks during bull markets and a negative one during bear markets.

10. Don’t Forget Taxes And Expenses.

Alternative mutual funds are often less tax-efficient and often have higher expenses than traditional stock and bond mutual funds. It may make sense to buy an alternative fund in a tax-deferred account, but if the fund will be in a taxable account, evaluate the after-tax returns. When you review expenses, remember that some alternative mutual funds are funds of funds and have two layers of management fees. Funds that short stocks as part of their investment strategy will have to pay short interest and dividend expenses in addition to management fees. When considering alternative mutual funds, review the components of the expenses to understand them and look for lower fee options that are less of a hurdle for a manager to overcome.

Now that they are seven years into a bull market facing extremely low bond yields, investors’ attraction to alternative mutual funds would be understandable. However, the proliferation of these funds in recent years makes thorough research and due diligence by advisors and investors even more important if they are to select strategies that will be a good fit for them.