Alternative funds suddenly look a whole lot better

The market sell-off highlights the virtues of hedging

Feb 8, 2018 @ 4:53 pm

By John Waggoner

If ever there were a time for alternative funds to shine, it would be now. And some of them are actually doing that.

The Dow Jones industrial average has been gyrating like a dozen hamsters in an exercise wheel. Thursday, the blue-chip index tumbled more than 1,000 points, falling 3.75%. It's at times like this that investors — and advisers — turn toward funds that offer some downside protection.

Which is exactly what alternative funds, or alts, try to do, by using hedge-fund strategies to reduce risk in a falling market. Long-short funds, for example, bet against weak stocks — a strategy that may make money in a bull market, but almost certainly will in a bear market. Market-neutral funds try to eliminate any correlation to a stock market benchmark, such as the Standard & Poor's 500, and make gains only on their individual stock holdings.

Unfortunately, over the past 12 months, few people have wanted to reduce risk. In 2017, for example, long-short funds only attracted $1.7 billion in assets, while market-neutral funds saw just $84 million in net new flows, according to Morningstar Inc. All told, alt funds welcomed $3 billion in net new assets last year, according to Morningstar — considerably better than the $119 billion net outflow from stock funds, but far worse than the $271 billion inflow to bonds.

"When volatility was low, it was hard to have any use for alternative funds," said Cleo Chang, senior vice president for alternative investments at American Century Investments. But the stock market's recent unpleasantness may make some investors more interested in them. Long-short stock funds have fallen 1.44% over the past week, while the S&P 500 has fallen 5%, including reinvested interest.

Top long-short this year: ProShares Long Online/Short Stores (CLIX), which is up 13% and admittedly not your typical long/short strategy. It shorts shares of brick-and-mortar stores and goes long on online retailers. A more diversified offering is Absolute Capital Opportunities (CAPOX), which is up 10.4%.

Knowing whichstocks to short and which to go long isn't easy, and many funds just aren't very good at it. "Not every team that can manage a long fund can manage a long-short fund," Ms. Chang said.

Probabilities Fund (PROTX), for example, shed 13.78% this week. And the three largest long-short funds (Boston Partners Long/Short Research, AQR Long-Short Equity and Diamond Hill Long-Short) are all down more than 4% this week, although all three have fallen less than the S&P 500.

Long-short credit funds, which use a similar strategy for bonds, have also fared well, despite a steep rise in the 10-year Treasury note yield this year. The average long-short credit fund has gained 0.29% this year, according to Morningstar.

These funds find bonds that are not well-correlated to the overall bond market, such as bank loans and mortgage-backed securities, Ms. Chang said. "Some — but not all — are floating-rate securities," she said.

Many of the most popular market-neutral fund have weathered the week pretty well. (Thursday's dismal losses are not reflected in these numbers).

Calamos Market Neutral Income, for example, the largest market-neutral fund, has fallen just 0.07% in the past week. While the fund has gained just 4.86% a year over the past three years — as opposed to 19.3% for the S&P 500 — investors who have held on are probably feeling grateful.

Of course, this kind of volatile market also breeds catastrophes. One exchange-traded note, which Morningstar categorizes with alt funds, collapsed under the market's breathtaking volatility. And the ironically named LJM Preservation and Growth fund (LJMAX), has plunged 82% this year — including a 57% drop this week alone.

Nevertheless, look for more investors to start asking about alts in these difficult times — particularly Baby Boomers, who not only have more money at risk, but less time left to lose it.

"They should soothe investors who have more of an adverse tolerance for risk," Ms. Chang said, "particularly if we were to go into a severe market break."

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