Dislocations give alt funds a chance to shine

Stock market volatility that has been giving investors and financial advisers so much angst over the past several weeks is having an entirely different effect on those who subscribe to the virtues of alternative-strategy mutual funds.

While the casual observer might see an S&P 500 Index that is down about 9% from the start of the year, a peek beneath the surface shows increased dislocation among sectors, industries and securities, which is the perfect environment for alternative strategies that can invest in both long and short directions.

“This is like nirvana for us, because if you can’t perform in this market, you’re toast,” said Brad Alford, chief investment officer at Alpha Capital Management.

In addition to finally giving many of the alternative-strategy fund managers something to cheer about, the market volatility is providing investors with a clearer picture of which alternative funds are actually earning their management fees.

For example, while the long-short equity fund category has generated an average decline of 5.66% since the start of the year, the performance of individual funds in the category ranges from a gain of 8.93% to a decline of 22.25%, according to Morningstar Inc.

MARKET-NEUTRAL FUNDS

It is a less extreme but similar story for market-neutral mutual funds, which have a category average decline this year of 39 basis points, while the individual funds’ performance ranges from a gain of 6.11% to a decline of 7.89%.

This is what financial advisers should be looking at right now, because the volatility has put these strategies to the test, essentially exposing the funds that have been charging alternative-strategy fees for little more than beta-hugging, long-only allocations.

Investors should expect bear market funds, which make downward bets on the stock market, to do well when stocks are falling. But strategies that can go both long and short should be living up to their promise of losing less when markets are down, just as they usually gain less when markets are up.

MOVING IN TANDEM

What is helping alternative managers right now is the increased level of dislocation among asset classes and various investment categories. That is a stark contrast from the multi-year bull market run that saw asset classes move virtually in tandem as investor sentiment went from risk-on to risk-off and back again since the financial crisis.

The dispersion can be seen by comparing the various price-to-sales ratios of the industries making up the S&P 500 index.

From the end of 2008 through 2009, when the industries were all trading closely in line on a valuation basis, the standard deviation was hovering around 1. But that has been steadily trending higher and is now close to 2, which is higher than it was in 2006 leading up to the financial crisis.

The higher the standard deviation, the greater the dispersion among the 63 industries making up the S&P.

For example, in the information technology sector, the Internet software services industry has a price-to-sales ratio of 7.7, which compares to 1.5 for the computers and peripheral devices industry on the low end. In late 2008, less than two points separated the valuations of the two industries.

In the consumer discretionary sector, the diversified consumer devices industry has a valuation of 3, which compares to 0.3 for the automotive industry on the low end of that sector. The auto industry has stayed virtually the same since 2008, but the valuation of consumer devices is up from a low of 1.6 during the financial crisis.

“This means a good long-short manager has a more fruitful opportunity set,” said Dick Pfister, founder and chief executive of AlphaCore Capital.

GOOD TIMES AND BAD

“This is the kind of environment that these strategies were bought to perform in, and this is the time for these portfolio managers to do what they do,” he added. “That’s why the category-average performance means nothing for alternative funds. This isn’t large-cap value, where they’re all basically the same. The funds that are down right now probably hugged the equity index and weren’t really hedging.”

A lot of alternative-strategy mutual funds were launched after the financial crisis. But in addition to comparing performance since the market’s recent bout of volatility, it would be prudent to compare the performance of these hedging strategies through good times and bad.

The Guggenheim Alpha Opportunity Fund (SAOIX), for example, is a long-short strategy that has gained 2.59% so far this year, but the fund’s 4.36% decline last year was well behind the S&P’s 1.38% gain, according to Morningstar.

Aside from 2011, when the fund’s 4.05% gain nearly doubled the S&P 2.11% gain, it slightly underperformed the stock index all the way back to 2008, when it lost two percentage points less than the S&P’s 37% drop.

Then there’s the Otter Creek Long/Short Opportunity Fund (OTTRX), a fund with a shorter history that has gained 4.99% so far this year. Last year it trounced the S&P with a gain of 9.57%, but in 2014, when the S&P increased by 13.69%, the fund gained 9.78%.

Most of these strategies have enough flexibility to get in trouble or outperform in just about any market environment, but what you want to focus on are funds that have proven an ability to lose less in down markets and stay close in up markets.

“This is the time, as an alternative strategy, you better be able to perform,” said Brad Balter, chief executive of Balter Capital Management.

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