Tumultuous stock market puts spotlight on liquid alternative mutual funds

The pitch most advisers get for liquid alternative funds is that they provide superior returns when adjusted for risk.

That’s a powerful lure in volatile markets when traditional diversification plays, such as international investments, haven’t helped.

And during the past 12 months, that pitch has hit home with investors and advisers: Liquid alt funds have been flying off the shelves. Investors poured a net $10.7 billion into such funds at the same time they sold a net $108 billion worth of U.S. stock funds, according to Morningstar Inc.

So how are the funds performing?

At first blush, not that badly. Consider long-short funds, which buy stocks that management expects to rise and sell short those it expects to fall. So far this year, the median long-short fund is down 4.38%, compared with a 7.78% loss for the Standard & Poor’s 500 index with dividends reinvested, according to investment research firm Morningstar.

The story is the same for market neutral funds, which attempt to hedge out the risk of the overall market and expose investors only to the risk of the fund’s individual stock picks. The median market neutral fund has fallen just 0.39%

And both fund categories have lower risk than the S&P 500 when measured by standard deviation. The S&P weighs in at a five-year standard deviation of 11.75. (Higher is more volatile). Market neutral funds have a 3.83 standard deviation, and long-short funds have an 8.3 standard deviation, according to Morningstar.

Morningstar includes four other categories in the alternative universe: bear market, managed futures, multicurrency and multi-alternative funds. Bear market funds, used mainly by market timers, have gained 13.53% this year, while multicurrency and multi-alternative funds are down 0.42% and 2.15%, respectively. Managed futures are up 2.17%.

ADVISERS WARY

But many advisers remain wary of alt funds.

One reason, of course, is that relative performance doesn’t sell well. Most investors will look at you blankly if you suggest a fund that has fallen half as much as the S&P 500. Funds that didn’t appear correlated in a bull market may be uncomfortably correlated in a bear market.

“If there’s a lesson out of the financial crisis, it’s that there’s a time at stress points where everything is correlated,” said Lane Jones, chief investment officer for Evensky & Katz/Foldes Financial Wealth Management.

And it’s equally hard to suggest an alternatives fund when the markets are rising. “In a bull market, market neutral funds don’t pay off as well,” said Timothy Mc-Intosh, chief investment officer of SIPCO Investment Management Co.

Indeed. The past five years, the average market neutral fund has fallen an average annual 1.57%, versus a 10.02% annual gain for the S&P 500. The average long-short fund has gained just 3.11% a year, Morningstar says.

For Mr. Jones, most long-short funds seem too highly correlated in down markets to be a useful part of a portfolio. The typical long-short fund invests mainly in large-company stocks, and that’s not an area where his firm believes active management can add much value.

But those aren’t the only problems with liquid alts:

Wide variations in outcome. While the median long-short fund held up reasonably well this year, picking the right fund was crucial. The worst-performing fund, Catalyst Hedged Insider Buying (STVAX), has fallen 19.83% this year. The best fund, CMG Long/Short (SCOTX), has gained 7.73%, according to Morningstar. Other variations in the alt category show similar extremes.

High expenses. The median expense ratio for market neutral funds is 1.63%, while the median expense ratio for long-short funds is 1.75%. “You’re paying nearly double what you’d pay for a traditional fund to lag or lose money,” said Todd Rosenbluth, director of ETF and mutual fund research for S&P Capital IQ.

Investment biases. “Our experience with market neutral funds is that there’s always some sort of fundamental factor bias in the investment model,” Mr. Jones said. For example, some funds tend to buy value stocks while shorting overheated growth stocks.

A further question is just how much better an alt fund is at reducing volatility and increasing risk-adjusted returns. Mr. McIntosh of SIPCO, for example, prefers funds that produce income, such as the Credit Suisse X-Links Gold Cov Call ETN (GLDI), which currently yields 10%. “You don’t get much of the upside from gold, but it does track gold prices over time,” he said.

THE RIGHT MIX

And choosing a mix of strategies isn’t easy, either, said Steve Janachowski, chief executive of Brouwer & Janachowski. He prefers multi-alternative funds, which offer a mix of strategies in one fund. But even a good multi-alternative fund can have a big hurdle: explaining the lackluster bull-market performance to clients.

“Everyone’s interested in alternatives when the market torpedoes,” Mr. Janachowski said. “Most people don’t have the patience with them during a bull market.”

However, Mr. Jones pointed out that the rush into alts has opened up some doors for investors. “Some very credible people are coming downstream to the market,” he said. The new funds are far better priced than hedge funds, which typically charge a 2% management fee and 20% of profits. And they are far more liquid than hedge funds, which often permit redemptions only quarterly.

While investment flows to alt funds have slowed — the group had $220 million in outflows in December, according to Morningstar — they remain tremendously popular. James Troyer, Michael Roach and James Stetler, managers of Vanguard’s Market Neutral fund (VMNIX), got Morningstar’s nod for Managers of the Year for running the $715.5 million fund.

GROWING POPULARITY

In fact, investors’ heightened interest in alts has forced one firm, mutual fund firm AQR Capital Management, to close two of its popular alternative funds, a move that protects existing shareholders when a fund has reached the limit of its ability to put money to work efficiently in a particular area. But that’s also often a sign that interest in a particular type of investment might be reaching a frenzy.

“If they’re turning down new money, it’s a sign that this trend has gotten too big too fast,” S&P Capital IQ’s Mr. Rosenbluth said. “No one turns down revenue.”