PORTFOLIO
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Unappealing
Alternatives
Investors have been flocking to alternative
mutual funds and ETFs — and are being
punished for it.
By Allan S. Roth
Investors have been pouring money into alternative mutual funds and ETFs in recent years, with assets soaring to $280bil-
lion in April from about $80 billion at
the end of 2007.
This trend may be attributed
to modern portfolio theory, which
states that risk-adjusted returns can
be enhanced by adding asset classes
that have low or negative correlations to the rest of a portfolio. That
means alternative funds in a client’s
portfolio should zig when her traditional stocks and bonds zag.
This would seem to be attractive
to a planner formulating a portfolio.
Unfortunately, an analysis of Morningstar data indicates that most alternatives have been producing significant
negative returns, and seem likely to
continue recording losses.
Morningstar defines an alternative
investment as any fund or ETF that
falls into one or more of the following
three buckets:
• Nontraditional asset classes (such
Financial-Planning.com
as commodities and currencies).
• Nontraditional strategies (such as
shorting or hedging).
• Illiquid assets (private equity, private debt).
Morningstar notes that once an
investment enters the mainstream,
it is no longer considered an alternative investment. To be considered a
good alternative investment, according to the research giant, a category
must produce positive, risk-adjusted
returns over a reasonable time frame
and exhibit low correlations to traditional investments.
7 CATEGORIES
Using these definitions, Morningstar
developed seven classifications of
alternatives.
There are three alternative catego-
ries that involve equities: Long-short
equity funds are the largest category
and are typically long stocks, with
betas typically between 0.3 and 0.8.
Market-neutral funds hedge out most
of the market risk and have betas
between minus 0.3 and plus 0.3. Bear
market funds take a net short expo-
sure to stocks and often use leverage.
