Morningstar recently published a paper titled “Liquid Alternatives Have Yet to Prove They Belong in Portfolios.” We have concerns with the analysis on multiple levels.
The Data Set
Morningstar’s data set—returns from the five-year period ending December 2017—is far too short to draw statistically meaningful conclusions about any set of strategies.
Granted that after completing the initial analysis of the funds within the alternative categories, the analysts did attempt to make up for the shortcomings of the primary data by considering the HFRI Fund Equally Weighted Composite Index, which is a hedge fund index and dates to 1992. However, we don’t see any value in such an analysis.
We don’t understand why Morningstar chose an index that doesn’t represent any particular asset class, style, or strategy. It includes more than 1,500 hedge funds that follow completely disparate strategies, ranging from China-focused, to convertible arbitrage, to fixed income arbitrage, to distressed, and so on.
The equivalent in the mutual fund world would be an index composed of a sample of hundreds of equity, fixed income, commodity, and currency funds, both traditional and alternative. It would never make sense to use such an index to attempt to draw conclusions about proper portfolio construction.
Not Just Any Five-Year Period
The five-year period used by Morningstar also just happened to be an extraordinary period for a balanced portfolio. Whether measured on 1-year, 3-year, or 5-year windows, on either overlapping periods or mutually exclusive periods, the hypothetical 60/40 portfolio used in the analysis at some point during the five-year span exhibited the best (or near the best) Sharpe ratios ever recorded for such a portfolio going back to 1980.
While it’s not exactly fair to say that this was a benchmark against which alternatives were judged, as it was a core portfolio to which alternatives were added, it is in effect quite similar. When you start with a portfolio that has exhibited about the best risk-adjusted returns that have ever been produced, it’s not easy to find something that will make a material improvement to the portfolio’s efficiency.
To demonstrate our point, we used the simple calculation that Morningstar explained in its paper to gauge how many different types of assets would have added value to the baseline portfolio over the past five years. We assembled a group of indices covering equities, fixed income, commodities, and currencies that were not already included in the portfolio. And while these are asset class indices, not funds, they are proxies for all the traditional, long-only mutual fund categories. For reference, Morningstar describes its binary test as follows:
“…if a liquid alternative fund’s expected Sharpe ratio exceeds the portfolio’s expected Sharpe ratio multiplied by the forecast correlation between the two, then adding the alternative to the allocation would be expected to improve its future risk-adjusted returns.”
In Exhibit 1 we present the results.
While not all of the assets covered in this table are mutually exclusive relative to Morningstar’s hypothetical portfolio, the results send a pretty clear message—there was very little that could have been added to that core portfolio that would have added value, at least by Morningstar’s measure (which, by the way, we would not advocate using to make portfolio decisions).
Additionally, we recognize that Morningstar also used an optimization process in an attempt to give these alternative strategies the “best” opportunity to demonstrate additive performance. However, because the ingredients were already at a disadvantage given the time frame, it was a futile exercise—as it would be to take the above results and optimize to Sharpe.
Tactical Allocation Funds are Alternatives? We Think Not
While there is room to debate what is or is not an alternative investment, the largest group of funds contained in the analysis were Tactical Allocation funds. Most funds in that category shift their allocations between U.S. and international stocks and bonds, providing traditional beta exposures along the way.
While we believe such strategies can be highly effective components of diversified portfolios, there is nothing about these funds that offers any kind of alternative risk premia, additional sources of alpha (save for timing), or true diversification that investors can count on when needed.
And guess what? Over a five-year period when the S&P 500 beat just about everything on both an absolute and risk-adjusted basis, anything less than being fully invested in U.S. large cap stocks was the “wrong” tactical call, with the benefit of hindsight at least. Point being, the argument we made about the extraordinary period we just came through rings true here as well. It would have been remarkable if many of these funds had added value to the 60/40 baseline portfolio.
Further, as we’ve shown numerous times, while we are tireless advocates for long/short equity strategies (we offer such funds), we acknowledge that they are still sources of equity beta, albeit in lessened forms. As a group, these funds have a beta that is quite similar to that of a 60/40 portfolio. As such, they resemble exactly that, a core portfolio (with additional sources of alpha and fewer constraints on managers to pursue alpha). Therefore, it’s not surprising that this group of funds would have struggled to make that 60/40 portfolio meaningfully more efficient.
A Category of Funds Doesn’t Add Value – What’s New?
Any analysis of a fund category, traditional or alternative, will show that as a group, funds don’t add value. Nobody in our industry can honestly argue otherwise. It’s a zero-sum game before fees and taxes. But even if only a small percentage of funds (15%?) generate true alpha, that is a large set of funds to consider, given that there are close to 7,500 mutual funds.
True manager due diligence, as opposed to simple quantitative scores that have no predictive power, is difficult, because asset management is difficult. It takes considerable expertise to identify quality managers. Passive investing has become such a force because without such expertise, it’s not even close to a coin flip. Investors shouldn’t be allocating to alternative categories, they should be allocating to managers. If an investor can’t identify a long/short manager who can produce alpha with some consistency, then there is no reason to allocate to long/short strategies. There are managers who produce alpha, so it’s imprudent to eliminate an entire category with the notion that liquid alts don’t work.
Our concern with Morningstar’s analysis isn’t actually the claim that an entire category of funds doesn’t add value—that’s axiomatic at this point in the evolution of our industry. Our concern lies in the overly simplistic and misleading analysis and the harm that could come from it. Investors who read this piece and decide to avoid all of these strategies—tools that can be valuable components to a diversified portfolio—based on what can only be described as rear-view mirror investing, will not be properly prepared for the future.
Investors allocate to alternative strategies for the unique characteristics of the strategies selected, not to get exposure to a category. Alternatives are useful for alternative risk premia, additional sources of alpha, leverage, risk offsets to exposures contained within the core portfolio, and true downside protection.