One upside to the stock market carnage of the past week or two is that the wildly popular alternative-strategy mutual funds, better known as liquid alts, have finally been tested on the open road.
The results? Well, they're mixed. But for financial advisers who have watched the liquid alternatives space balloon to nearly $180 billion in more than 470 mutual funds, the sudden surge in market volatility allows for some much-needed analysis based on something other than clever sales pitches and back-tested data.
“The rubber is finally meeting the road,” said Thomas Meyer, chief executive of Meyer Capital Group. “You have to keep these [alternative-strategy] funds on a short leash, and we will not tolerate a manager that is supposed to provide a downside buffer that goes down with the market.”
Mr. Meyer, who is a strong proponent of diversification into alternative strategies, also has been openly critical of “all the untested crap that's out there.”
Jason Kephart, fund analyst at Morningstar Inc., said with more than half of the liquid alt funds on the market having been launched within the past two years, most haven't experienced extreme or even elevated volatility, and so are getting tested for the very first time.
That volatility — 300-point swings in the Dow Jones Industrial Average on nearly a daily basis over the last couple of weeks and the accompanying spike in the Chicago Board Options Exchange's volatility index, the VIX — will tell a lot about which alt funds perform as advertised and have what it takes to be a core portfolio holding, he added.
“Funds that have performed poorly during this period will lose some assets,” Mr. Kephart said. “But even if they did well, you will still want to know why and how.”
In the historical context of the stock market, a few weeks is a relatively brief moment in time, but if a strategy is charging higher fees for the kind of alpha brainpower that is supposed to buffer the downside, the past month has given investors a pretty good measuring stick.
Nadia Papagiannis, director of alternative investment strategy for global third-party distribution at Goldman Sachs Asset Management, used the extreme volatility on Wednesday to test the liquid alt category. Even though the S&P 500 finished the day down just 0.8% (after dropping more than 3% intraday), the carnage was best illustrated by the VIX, which spiked to 31.06 — a fresh 52-week high — from the low teens.
Of 81 long-short mutual funds that Ms. Papagiannis looked at, 70 finished the day ahead of the S&P, but only 21 had positive returns.
Overall, long-short funds as a group had a category average decline of 4.1% over the 30-day period that ended Wednesday. That compares with a 6% decline in the S&P 500 Index over the same period.
While falling less than a long-only stock index might seem like a reasonable hedge, a closer look at the category underscores the kind of extreme performance dispersion for which alternative strategies are known.
The top two performers during that one-month period, Catalyst Insider Long/Short (CIAAX) and KKM US Equity Armor (UMARX), each gained 4%. But most of the category produced negative returns, trailing all the way down to an 11.6% drop by Invesco Long/Short Equity (LSQAX).
Multialternative funds, which are often promoted as providing broad alternative exposure, produced a category-average decline of 2.6%. But the range included a 4.2% gain by Cane Alternative Strategies (CDMIX), a 2.5% gain by Arrow Alternative Solutions (ASFTX) and on the other end an 8% decline by KCM Macro Trends (KCMBX).
In this category, Ms. Papagiannis analyzed the performance of 84 funds against a traditional benchmark portfolio of 60% stocks and 40% bonds, which was down 0.01% on Wednesday. The bad news is that only 16 of the 84 funds beat the 60/40 portfolio.
“If you're managing a multialternative fund and you can't beat a 60/40 portfolio, why bother?” Ms. Papagiannis wondered. “Overall, what we saw was a good showing of the potential of various alternative strategies, but we also saw more proof that there is a lot of performance dispersion with alternatives.”
Of the 14 liquid alt subcategories tracked by Morningstar, bear market funds, not surprisingly, did the best over the 30-day period that ended Wednesday, generating a 9.4% average gain, led by a 25.3% advance by Ramius Strategic Volatility (RVOAX) and a 19% gain by ProFunds Ultra Short International (UXPIX). The worst performer in the category, Teton Valley (TTNVX), gained 4.5%.
One of the surprises over the past month was managed futures funds, which had fallen largely out of favor since generating standout positive performance during the 2008 financial crisis.
The category, which gained 1.9% over the past month, was led by a 7.4% gain from Direxion Indexed Managed Futures Strategy (DXMAX) and a 7.2% gain by Equinox Campbell Strategy (EBSAX). On the other end of the spectrum, 361 Global Managed Futures Strategy (AGFQX) declined by 7.7%.
“This is the first time in a while we've seen managed futures bring something to the table,” Mr. Meyer said.