Goldman pares down liquid alts, presses Morningstar to follow suit

The evolution of the alternative-strategy mutual fund universe continues with an effort by Goldman Sachs Asset Management to reduce, redefine and generally re-categorize the way Morningstar Inc. has been cataloging these funds over the past half-dozen years.
From certain angles, it might look like Goldman is trying to play in Morningstar’s backyard, and that might be the case. But for financial advisers and investors, it should be seen as a step toward bringing more clarity to what is becoming a large and unwieldy heap of liquid alternative mutual funds.
As part an analysis it calls the Liquid Alternative Investments Navigator, Goldman cut the total liquid-alt fund universe down to 326 funds from the 621 tracked by Morningstar through December.
Along the lines of evaluating liquid alt funds on the same plane as hedge funds, Goldman also divided the funds into five simple categories, as opposed to Morningstar’s 15 different categories.
By Goldman’s count, the liquid alt space should include 92 equity long-short funds, 88 tactical macro funds, 74 multi-strategy funds, 38 event driven funds and 34 relative value funds.
“The point of this is to help advisers better understand and allocate to liquid alternative strategies,” said Nadia Papagiannis, director of alternative investment strategy for GSAM’s global third-party distribution.
The paring-down process involved eliminating broad groups of funds that employed option-income strategies that don’t belong in a long-short category, as well as any nontraditional bond funds that only focused on credit risk, but ignored interest-rate risk.
“What Goldman is doing needs to be done, because it’s the next step in re-categorizing liquid alts,” said Dick Pfister, president and chief executive of AlphaCore Capital.
“Morningstar has tried their best, but they really haven’t taken a hedge fund point of view,” he added. “What Goldman did is still not perfect, but they did a very good job of bringing it closer to the way hedge funds are categorized.”

How Morningstar sees the liquid alt universe

Source: Morningstar Inc.

ASKING TOO MUCH
Considering the fast-growing pace of the liquid alts category and that many of the funds have only been around a few years, a perfect categorization system is probably asking too much.
In fairness to Morningstar, the process of categorizing hundreds of individual funds with limited track records is clearly more art than science. But Goldman has looked under the hood of the funds and removed those it deemed unfit for any true alternative category.
“Goldman is bringing some legitimacy to alternative mutual funds by using the hedge fund category process, and saying ‘These guys are doing things like hedge funds,’” said Jonathan Belanger, AlphaCore’s director of research.
For investors and advisers, this means a cleaner universe of liquid alt funds that can be more easily measured against specific category performance, which is no small thing in the alternatives space.
For example, the 2014 median return of Goldman’s long-short equity category was 3%, which compares to closely to the 2.8% return by Morningstar’s long-short equity category. But the Goldman category’s correlation to the S&P 500 Index last year was 0.8, while Morningstar’s was 0.98, which is not what you want from an alternative strategy.
“Based on beta and correlation, alternative investment returns should not be moving in lockstep with stocks and bonds,” said Ms. Papagiannis. “Alternatives are supposed reduce the overall portfolio volatility, and reduce the impact of a large market drawdown.”

How Goldman see the liquid alt universe

Source: Morningstar Inc.

AVAILABLE TO ADVISERS
Goldman is making its analysis and categories of liquid alt funds available to any adviser who wants it, but that’s still a long way from changing the popular and user-friendly services provided by Morningstar.
And Morningstar doesn’t appear ready to make any big changes any time soon.
“We don’t want to really nitpick the strategies that we already have,” said Josh Charney, an alternatives analyst at Morningstar.
“The whole point of our categories is to generate star ratings, and we’re trying to lump funds based on investor experiences,” he added. “The difference in categories is the approach: They’re doing it by strategy and we’re doing it more by return expectation based on market exposure.”
Ms. Papagiannis, who worked alongside Mr. Charney at Morningstar until she left for Goldman in January 2014, acknowledged the Morningstar evolution with regard to liquid alt funds, but believes they need to take it further.
“When I got there in 2008, there was one category for alternatives; everything went into long-short equity,” she said. “I wanted Morningstar’s categories to look like the Hedge Fund Research categories, and I helped evolve the alternative categories.”
While Goldman’s tighter groupings will make it easier for advisers to sift through the growing list of liquid alt funds, the research process will never likely be as easy as picking a standard large-cap growth fund. And maybe that’s the biggest hurdle facing liquid alternatives, now and forever.
“If an adviser commits to, say 10% alts, they still don’t know what funds to buy,” Ms. Papagiannis said. “You still have to do due diligence, and this is the problem, because it requires a lot of due diligence for a very small part of the portfolio.”

Related Topics: Goldman Sachs & Co., Morningstar Inc.