Some advisers using ill-suited benchmarks to measure alts performance

Morningstar survey shows a quarter of advisers look to standard index benchmarks to evaluate 'liquid alts'

Jul 7, 2014 @ 12:18 pm

By Trevor Hunnicutt

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While financial advisers are turning in droves to alternative investments, many are evaluating those investments against benchmarks that suggest, possibly falsely, that they are underperforming.

The most popular way for advisers to evaluate the performance of their investments is using a standard benchmark index rather than measuring performance against the fund's competitors, customized benchmarks or risk-adjusted analysis.

A quarter of advisers are using such benchmarks as the S&P 500 or Russell 2000 to evaluate alternatives funds, according to a survey released Monday by Morningstar Inc. (The remaining three-quarters use a variety of methods.)

Some analysts and industry executives say those index benchmarks are poorly suited to the task of evaluating the performance of the funds, which employ a variety of exotic strategies and aim for many different goals.

“The fact that people are still going to the S&P 500 or other standard benchmarks is indicative of an issue,” said Josh Charney, an analyst for Morningstar. “I don't think it's really acceptable to have a benchmark that's completely different from the strategy.”

Many long-short equity funds, which tend to invest in large-cap stocks and employ hedging, are often measured against indexes — such as the S&P 500 — which are significantly more volatile then the funds themselves.

But advisers still are evaluating those funds by standards developed for products designed to exceed market benchmarks. Many alts funds are designed to achieve other targets, like reducing volatility or consistent returns in both an up and down market.

In most cases, that has meant the funds have not fared as well, in terms of total performance, as funds more exposed to the bull market.

David Lafferty, chief market strategist at Natixis Global Asset Management, agrees it can be misleading to measure the performance of an alternative fund against common index benchmarks.

“That standard against broad equities is a little bit crazy because the vast majority of these funds take on far less risk than the S&P 500,” Mr. Lafferty said. Boston-based Natixis' subsidiaries manage alternatives funds. “If two managers in the same space had different performance, even if their volatility was significantly different, that's still a headwind for the 'underperforming' manager. The population of advisers still vote with their feet, and they're still voting based on performance.”

He recommends advisers use “multiple measures of risk,” including technical measurements like maximum “drawdown” and downside “capture,” to communicate with clients about their investments.

Despite some misevaluation, total assets in alternatives funds topped $300 billion in May, growing by more than 18% each year since 2009, excluding market appreciation.

In 2013, assets in alternative funds grew by 43%, excluding market appreciation, making it the fastest-growing mutual fund product — a title it's held now for three years. Eighty-nine products were launched in this space last year, drawing $95.6 billion in flows to alternative mutual funds, Morningstar said.

The fastest growing subcategories have been long-short stock funds (growing more than 80% in 2013), nontraditional bond funds (79%) and "multi-alternative," a catchall for fund-of-alts-funds products (57%).

The research firm, along with the magazine Barron's, conducted the annual survey in March among 372 institutional investors and 301 advisers.

The survey's respondents are not representative of the adviser space. For instance, registered investment advisers accounted for more than half of the Morningstar survey's respondents and wirehouses made up just 1%. The wirehouse and RIA workforces each make up about one-seventh of advisers in the U.S., according to Cerulli Associates Inc., a research firm.

But the survey did offer insights into the way those advisers approach asset allocation in an era of increasing alternative investment options available in mutual funds and ETFs, a product the industry often markets as “liquid alts.”

Advisers have been turning to the products despite significant gains in long-only equity market exposures. The S&P 500, for instance, is up nearly 190% since March 2009.

“With the markets up, you think people would pile their money into that, but instead they're piling their money into these products that have a much lower return profile,” Mr. Charney said. The strength of these products during a bull market that might hamper growth shows they are likely to continue to draw interest for advisers going forward, he said.

Nearly a quarter of advisers said they are allocating 11% to 15% of client portfolios to alternative investments. One in ten advisers is putting more than 25% of clients' money into alternatives.

More than three-quarters of advisers said they're looking for the diversification benefits and lack of correlation with returns of the broader market. Nearly half look to the funds for a better risk-adjusted investment profile.

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