Alternatives are earning their keep in 2015

Solid relative performance makes the case for diversification

Feb 10, 2015 @ 1:35 pm

By Jeff Benjamin

The U.S. equity markets have calmed down since the rocky start to 2015, but as hedge fund indexes start rolling out January performance data, the numbers are showing how using alternatives to diversify makes sense.

In a month that saw the S&P 500 Index drop by 3%, most broad hedge fund indexes gained between 1% and 1.5%. Of the seven primary alternative mutual fund categories tracked by Morningstar Inc., only long-short equity was negative in January, posting a 1.4% decline.

The managed futures mutual fund category was the top liquid alternative performer in January with a 3.9% gain, while the bear market fund category predictably did well, gaining 2.8% for the month.

Market neutral, multialternative, and multicurrency funds and nontraditional bonds rounded out the Morningstar categories with January gains of between 0.1% and 0.8%.

In 2014, every liquid alt fund category underperformed the S&P's 13.7% gain.

Critics, and even some proponents of alternative strategies, will point out that one month is a narrow window for gauging the true value of an investment. But since the current bull market in U.S. equities kicked off in early 2009 there have been few opportunities to really test the mettle of the fast-growing liquid alternatives space, which now includes more than $180 billion in nearly 500 mutual funds.

Joseph Witthohn, vice president at Emerald Asset Management, not only bristles at the focus on one month's performance, but also takes issue with comparisons to long-only benchmarks like the S&P.

“Not only are people commenting on things over a very short term, but they're stacking liquid alts and hedge funds against the broad equity market, which is certainly not a fair, nor proper, comparison,” he said. “These are very different animals and should be separated. However, the insatiable need to make comparisons often cause the zookeepers to feel they must continuously open the cages.”

While Mr. Witthohn makes excellent points about the comparisons to the broad equity markets, the fact is the broad equity markets represent the highest-profile benchmarks, and they represent an area that could easily be over-weighted in an investor's portfolio.

Bradley Alford, chief investment officer at Alpha Capital Management, who manages two liquid alts mutual funds, also wasn't ready to make too much of the one-month relative performance advantage over stocks.

“It's a small test for liquid alts; a real test would be a 10% drawdown for stocks,” he said. “But if it helps keep people invested, I guess it's a good thing.”

In terms of the one-month performance comparison, Bob Rice, managing director at Tangent Capital, summed it up nicely.

“It only takes a few days of hot weather to prove that air conditioning is a good idea,” he said. “January is highly instructive; all the more so because the results simply correspond to common sense.”

Mr. Rice explained that over any down period for equities — “from one day to 10 years” — strategies that are less than 100% net long stocks will almost always generate superior returns.

“Yes, the alternatives will lag, in gross return terms, a straight-up market, as we've seen, but is that what you're willing to bet on?” he added. “By the way, in my view, the market is very fully priced by nearly every historical measure, and I think U.S. investors are underpricing a slew of global risks because they sense an improving economy at home.”

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