Demystifying Alternatives - InvestmentNews

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Demystifying Alternatives

× Nadia Papagiannis, Director of Alternative Fund Research

InvestmentNews Alternative Investments Conference, October 2012



2

Workshop Agenda

× Alternatives 101: What, Why, and How

× Alternatives 201: Classification & Analysis

× Alternatives 301: Implementation



3

× What is an Alternative Investment?

× Why does one need them?

× How can one access them?

Part 1: What, Why, and How



4

What is an Alternative Investment?

× An investment can be defined as “alternative” if it falls into one or more of the

following three buckets:

1. Non-traditional asset classes (i.e. commodities and currencies).

2. Non-traditional strategies (i.e. shorting or hedging).

3. Illiquid assets (i.e. private equity, private debt).



5

What is an Alternative Investment?

× Dynamic classification.

× Once an investment becomes mainstream, it is no longer “alternative”.

× Emerging market stocks, listed REITs.

× Legal structure does not define the investment.

× Hedge funds aren’t necessarily alternative, and mutual funds

aren’t necessarily traditional.

× A good alternative investment is one that produces positive risk-adjusted

returns (over a reasonable time frame) and exhibits a lower correlation

to traditional investments.



6

History of Alternatives

1946

First Private Equity

Funds

2008

Financial Crisis

and rise of Liquid

Alternatives

1980’s

Rise of Global Macro

Hedge Funds

; 1949

First Hedge Fund

1966

Fortune Magazine article

popularizing Hedge Funds

1997

Repeal of “short-short” rule

1990’s

The Yale “Endowment

Model” catches on



7

Why Invest in Alternatives?

× Modern Portfolio Theory:

× Positive Sharpe ratio (or other risk-adjusted return measure) + lower

correlation = improved portfolio risk-adjusted return.

× Portfolio variance: p

2 = Σw

i

2

i

2 +Σ

iΣ

jw

iw

j i jρ

ij.

× Avoiding/reducing downturns can improve long-term wealth.



8

Equity-Heavy Traditional Portfolios



9

Traditional Asset Class Correlations Rise During Crisis Times

52-Week Correlation to S&P 500 TR 9/1/2007 8/30/2008 8/29/2009 8/28/2010 8/27/2011

Russell 2000 TR USD 0.91 0.88 0.96 0.93 0.95

MSCI EAFE GR USD 0.79 0.60 0.88 0.85 0.87

MSCI EM GR USD 0.63 0.48 0.85 0.84 0.72

BarCap US Corp IG TR USD -0.10 -0.27 0.12 -0.28 -0.43

BarCap US Corporate High Yield TR USD 0.62 0.59 0.68 0.63 0.46

BarCap Municipal TR USD -0.06 -0.19 0.01 -0.24 -0.39

JPM EMBI Global TR USD 0.55 0.38 0.71 0.63 0.05

BarCap Global Treasury Ex US TR USD -0.22 -0.48 0.02 0.01 0.00

BarCap US Treasury TR USD -0.31 -0.53 -0.36 -0.64 -0.57



10

How Can One Access Alternatives?

× Private partnerships/offshore corporations (Hedge Funds)

× Accredited investor status, high minimum investments,

performance fee, no required transparency.

× The most options.

× Mutual Funds

× Daily redemptions, no performance fee, SEC registered,

quarterly holdings.

× Ample options, most new.

× Exchange Traded Funds

× Intraday trading, daily holdings, low cost.

× Fewer options.



11

Growth of Hedge Fund Database

Label Label Label

0

100

200

300

400

500

600

Sep Dec Mar

2008

Jun Sep Dec Mar

2009

Jun Sep Dec Mar

2010

Jun Sep Dec Mar

2011

Jun Sep Dec Mar

2012

Label Label Label

Morningstar Hedge Fund Database Assets USD Bil

Graph Title Here


Graph Title Here


Graph Title HereGraph Title Here




12

Growth of Alternative ETF and Mutual Fund Assets

0

50

100

150

200

250

300

350

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 09-2012

Mutual Funds ETFs

Assets in Liquid Alternative Vehicles USD BilAssets in Liquid Alternative Vehicles USD Bil

Assets in Liquid Alternative Vehicles USD BilAssets in Liquid Alternative Vehicles USD Bil



13

Alternative Mutual Fund Flows

-10

0

10

20

30

40

50

2007 2008 2009 2010 2011 09-2012

Bear Market Currency Long/Short Equity Managed Futures

Market Neutral Multialternative Nontraditional Bond

Flows Into Alternative Mutual Funds USD Bil



14

× Morningstar’s Alternative Classification System

× The 5 P’s of Alternative Investments

× Sample Analysis

Part 2: Classification and Analysis



15

Classification of Alternative Investments

× By asset and directionality/trading strategy.

× Equity, debt, or derivatives.

× Can be further classified by geography.

× Net long (directional), net short (directional) or neutral

(non directional) exposure.

× Gross Long (all long positions) – Gross Short

(all short positions) = Net long or short.

× More classifications for hedge funds than for mutual funds or ETFs.

× Classifications are similar across legal structure and geography.



16

Classification Chart

Trading

Commodities



17

Category: Long-Short Equity

× This is the largest category in terms of number of funds and assets.

× These funds take a hedged, net-long exposure to the stock market.

× Typical beta ranges between 0.3 and 0.8, averages 0.6.

× Several variations on the strategy:

× Long and short directional bets on stocks/stock indexes.

× Wasatch Long/Short FMLSX, Mars Hill Global Relative Value GRV.

× Long stock + long puts/short index futures or ETFs.

× Hussman Strategic Growth HSGFX.

× Long stock + short calls+ long puts.

× Gateway GATEX, Powershares S&P 500 Buy Write PBP.



18

Category: Market Neutral

× These funds hedge out most equity market risk, and exhibit betas to stock indexes

of between -0.3 to 0.3.

× Risk/return levels are similar to bond funds.

× Three major strategies: equity market neutral, merger arbitrage, and convertible

arbitrage.

× Equity Market Neutral:

× These funds take long and short positions in stocks such that the

market risk in the long positions is virtually offset by the short positions.

× The goal is to isolate “alpha” from stock selection.

× JPMorgan Research Market Neutral JMNAX, Proshares RAFI Long/Short

RALS.



19

Category: Market Neutral (continued)

× Merger Arbitrage:

× These funds buy target stocks and short the acquirer

(stock-for-stock transaction) or short calls (cash transaction).

× The goal is to isolate the premium paid for the target.

× Collecting premium is selling insurance on the deal closing.

× Merger Fund MERFX, Credit Suisse Merger Arbitrage CSMA.

× Convertible Arbitrage:

× These funds buy convertible bonds and short the stocks of the same

issuer.

× The goal is to benefit from the mispricing of the convertible bond,

which includes an embedded option.

× Convertible bond holders are paid an illiquidity premium.

× Calamos Market Neutral Income CMNIX.



20

Category: Bear Market

× These funds take a net short exposure to stocks.

× Most funds in the category are inverse and levered-inverse index funds.

× These funds, like other “tail-hedges,” are not good long term investments.



21

Category: Nontraditional Bond

× These funds invest primarily in debt (all types) but hedge duration risk, credit risk, or

both.

× Some funds focus on sovereign developed or emerging market credit, interest rates,

or currencies.

× Eaton Vance Global Macro Absolute Return EAGMX.

× Others focus on domestic corporates or munis.

× Dreihaus Active Income Fund LCMAX, Forward Credit Analysis

Long/Short FLSFX.

× Some are pure interest rate strategies.

× Rydex Long/Short Interest Rate RYBSX.

× iPath US Treasury Steepener/Flattener FLAT/STPP.

×



22

Category: Managed Futures

× These funds take long and short bets on futures contracts based upon positive or

negative price momentum.

× Systematic, automated strategies, which can range in volatility.

× Usually, the funds diversify into various asset classes (equity indexes, interest rates,

currencies, and commodities), but some don’t:

× AQR Managed Futures AQMIX, WisdomTree Managed Futures WDTI.

× Direxion Financial Trends DXFCX, Forward Commodity L/S FCMLX.

× Some funds are funds of hedge fund managers:

× Mutualhedge Frontier Legends MHFAX, Altegris Managed Futures

MFTAX, Princeton Futures Strategy PFFAX.



23

Category: Currency

× These funds invest in short-term (non U.S.) government debt or currency

futures or forwards.

× Most take a short USD exposure:

× Oppenheimer Currency Opportunities OCOAX, Powershares DB US

Dollar Index Bearish UDN.

× Most mutual funds are actively managed and diversified, while most ETFs are single

currency indexes.

× Other strategies include momentum or carry (long high-yield, short low-yield)

strategies.

× PowerShares DB G10 Currency Harvest DBV, Merk Absolute

Currency MABFX.

× Risk/return profile similar to bond funds.



24

Category: Multialternative

× These funds offer a diversified mix of alternative strategies, accessed through

separate accounts, ETFs, or mutual funds.

× Most, but not all, multialternative funds are also multimanager:

× Absolute Strategies ASFIX, Hatteras Alpha Hedged Strategies ALPHX.

× Some are managed in-house, though:

× AQR Multi-Strategy Alternative ASAIX.

× Some multi-alternative funds include allocations to more traditional investments,

such as publicly traded REITs or long only commodity strategies.



25

Volatility

× These funds trade equity options or VIX futures to take advantage of volatility

(long or short).

× Proshares VIX Short-Term Futures VIXM, Bishop Volatility Flex BVFVX.

× Not yet a mutual fund category (insufficient number of funds).



26

Analyzing Alternative Mutual Funds



27

Morningstar Analyst Ratings for Alternative Mutual Funds

× Debuted in June 2012.

× 45 funds, 75% of assets.

× Goal is 80 funds and 85% of assets.

× Same 5 Pillars: people, parent, process, performance, price.

× Same rating system: positive (gold, silver, bronze); neutral; negative.

× Unique application for alternative mutual funds.



28

Morningstar Analyst Ratings: 5 Pillars

Alternative Fund Application

× Hedge fund track records.

× Experience with shorting and risk

management is key.

× Key man risk.

× Reasonable investments in funds.

Pillar

× People

× Parent × Boutique shops.

× Series Trusts:

× Trustees spread thin with little or no

investment in their funds.

× Close eye on product launches and

capacity constraints.



29

People: Highbridge Statistical Market Neutral HSKAX Snapshot



30

Parent: TFS Market Neutral TFSMX Snapshot



31

Morningstar Analyst Ratings: 5 pillars (continued).


× Transparent and repeatable.

× Shorting process must differ from long

security selection:

× Timing is key.

× Position limits.

Pillar

× Process

× Risk management process is essential:

× Top-down market exposure limits.

× Bottom-up position loss limits.

× Steps to increase and reduce risk.

× Transaction costs.



32

Morningstar Analyst Ratings: 5 Pillars (continued).


× Short mutual fund track records.

× Only 31% have Morningstar (star)

ratings.

× Even fewer endured 2008 crisis.

× Categories are very heterogeneous.

× Makes Morningstar Ratings less

meaningful.

× Lack of industry-standard benchmarks.

× Strategies can have markedly different

return profiles in different market

environments.

× Look at statistics such alpha, beta,

correlation, upside/downside capture,

bear correlation, maximum drawdown.

Pillar

× Performance



33

Performance: JP Morgan Strategic Income JSOAX Snapshot



34

Morningstar Analyst Ratings: 5 Pillars (continued)


× More expensive than stock and bond

funds.

× Use net expense ratio rather than

gross expense ratio.

× Managed futures funds charge

performance fees which are not

always included in the expense ratio.

Pillar

× Price



35

Price: Gateway GATEX Snapshot



36

Average Annual Report Net Expense Ratios

*Prospectus Net Expense Ratio, which includes acquired fund fees

Alternative Mutual Fund Categories Average Annual Report Net Expense Ratio

Bear Market 1.96

Currency 1.45

Long/Short Equity 2.02

Managed Futures 2.73

Market Neutral 2.08

Multialternative* 2.04

Nontraditional Bond 1.25



37

× Strategy Selection

× Allocation

Part 3: Implementation



38

Selecting the Best Strategies

× Look for strategies that will have low correlations to each other and to

your existing portfolio.

5-Year Correlations



39

How to Allocate to Alternative Investments?

× Options:

× Multi-Alternative one-stop shop.

× How big is the alternative “bucket”?

× Where to allocate from?

× Pick a few strategies yourself.

× How to weight?

× Where to allocate from?



40

Allocation (continued)

× Choosing a Multi-Alternative Manager:

× Fewer managers are better.

× Why dilute alpha?

× Easier to determine risk/return drivers.

× More alternative is better—true diversification.

× How much to allocate?

× Look at 5-year correlations and betas to traditional investments.

× More risk averse, higher allocation.

5-Year Statistics

(ending 5/31/2012) Beta to S&P 500 Beta to BarCap US Agg Correlation to S&P 500 Correlation to BarCap US Agg

Maximum 0.77 1.55 0.94 0.35

Minimum 0.13 0.20 0.46 0.09

Average 0.41 0.57 0.78 0.20



41

Simple DIY Alternatives Portfolio

× Choose three non-correlating strategies: long-short equity, market neutral, and

managed futures.

× Long-short equity allows the opportunity to participate in stock

market growth.

× Managed futures offers growth, but from a different source.

× Market neutral offers downside protection.

× For a larger portfolio, consider a currency fund and/or a non-traditional bond fund.

× Equal weight.

× If one selects the right funds, the more one allocates, the better.

× Arbitrage ARBFX, Guggenheim Managed Futures Strategy RYMTX, and

Marketfield MFLDX.



42

Simple DIY Alternatives Portfolio



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Simple DIY Portfolio

× Inception 8/1/2007, inception of the youngest fund.

× Rebalanced quarterly.

× Alternative allocation funded out of equities.

× 5%, 10%, or 25% weights, equally divided into three funds.

Statistics (ending

5/31/2012) 1-Yr

Return 3-Yr

Annlzd

Return

Since

Inception

Return

Sortino

Ratio

(since

inception)

Sharpe

Ratio

(since

inception)

2011

Drawdown

07-22 to

08-08

2010

Drawdown

04-26 to

07-05

Financial

Crisis

10-9-07 to

03-09-09

60-40 Index portfolio 3.36 12.31 3.40 0.39 0.28 -9.21 -8.37 -34.77

3 Alt Demo Portfolio 5% 3.22 11.56 3.55 0.43 0.30 -8.49 -7.89 -32.03





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Questions & Comments

× Nadia Papagiannis, Alternative Investments Analyst

[email protected]

312-348-1400

× Website:

http://advisors.morningstar.com/advisor/alternative-investments.htm




Demystifying Alternatives - InvestmentNews

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