DERIVATIVES
Examining derivative funds, the man-
aged futures category had some suc-
cess early on but lost 7.22% in the
last year. These funds generally use
momentum strategies, such as bet-
ting the price of oil will continue to go
up faster than the market thinks. It’s
important to note that, in the aggre-
gate, not a penny has ever been made
in the futures market. If someone sells
an oil future, someone else has to buy
it, even if it’s a market maker like the
Chicago Board Options Exchange. Pro-
ponents of this strategy point to cer-
tain parties, like airlines, that are will-
ing to pay an insurance premium to
fix the price of a key commodity, like
bias, but feels strongly that the strategy
itself is valid.
hIgh coSTS, Too fEw wInnERS
Financial planners strive to help clients
minimize risk, and alternatives seem
to be an answer. But Morningstar data
shows that investing in these alternatives has resulted in losses. While this
analysis has simplified the descriptions
of the strategies that these fund categories use, future losses for most categories seem very likely. And though long/
short equity, nontraditional bonds and
multi-alternative funds may generate
long-term gains, these gains are likely
to be modest.
This doesn’t mean there aren’t specific funds within each category that
have had handsome returns. Even
in zero-sum game categories, some
Among alternative funds, only nontraditional bonds had positive
returns in the past 1-, 3- and 5-year periods, and those returns were small.
jet fuel. This is dubious in the absence
of readily available studies. Thus, the
expected return of this category is a
pure zero before trading costs, and the
2.73% annual expense ratio is the highest of all alternative categories.
Terry Tian, an alternative investments analyst at Morningstar, disagrees that managed futures funds
should have an expected return of
zero before costs. He notes that currency futures alone have a $4 trillion
daily trading volume and that managed futures make up a small amount
of this trading and can deliver positive
returns. He believes the strategy can
exploit traders’ behavioral biases. Tian
points out that the Morningstar MSCI
Systematic Trading Hedge Fund Index
has generated returns greater than the
total returns of the S&P 500 since 1996.
He does concede that the hedge fund
database suffers from self-reporting
rently near zero.
The nontraditional bonds category
has achieved positive returns over the
past one-, three- and five-year periods. Unfortunately, the returns have
been quite small compared with the
Barclays Aggregate Bond Index. For
example, the category returned 1.66%
annually over the five-year period,
while the bond index returned 6.63%
annually. The use of derivatives to
manage interest rate risk resulted in
lowering returns.
The last category, multi-alternative funds, used multiple strategies yet
actually provided little diversification,
with a 0.94 correlation to the moderate stock/bond portfolio. This class
turned in losses over the past one and
five years. Curiously, it returned 4.23%
annually over the three-year period,
possibly benefiting from the three-year
bull market for both stocks and bonds.
funds must be winners. Tian believes
Morningstar’s new forward ratings
can identify good funds for investors
and that, by picking the right funds, an
advisor can improve the risk-adjusted
return for a client’s portfolio.
While some of these strategies are
better than others, all have high costs
and, in the aggregate, have turned in
negative or low returns. This is a consideration that must be taken into account
when constructing portfolios. FP
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado
Springs, Colo. He also writes the
Irrational Investor column for CBS Money-Watch.com and is an adjunct faculty
member at the University of Denver.
