After a couple of rough years, 2017 is looking a little better for liquid alternatives.
This article was originally published in the August 2017 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.
Liquid alternative funds are hedge-fund-like strategies available in a '40 Act fund that seek to provide alternative (little or no equity or bond beta) sources of returns, and therefore diversification, to a stock-bond portfolio. Currently, most of these alternative mutual funds have short track records and are rather pricey. As a result, we have no funds with a Morningstar Analyst Rating of Gold, only seven Silver-rated funds, and 25 Bronze-rated funds. In addition, over the past few years, it has been difficult for these funds to demonstrate their diversifying capabilities, as equity markets continued their multiyear rally. Performance in 2017 is looking a little better, but liquid alternative funds still face tough comps against a rallying market. Below are funds that have earned Morningstar Medalist ratings with good processes and experienced managers.
Silver-rated Boston Partners Long/Short Research BPIRX identifies long and short names using valuations, current business fundamentals, and momentum. This stock-picking process is employed across the firm's long-only and long-short funds with solid results. For the year to date through August 2017, the fund returned 5.3%, placing it in the third quartile relative to its long-short equity Morningstar Category peers. But in each calendar year since its inception in 2010, the fund's performance has landed in the top half of its category. Key to this fund's success has been Boston Partners' ability to traverse a difficult short-selling environment. For its short portfolio, the managers focus on overvalued growth stocks. In most years, the fund has been able to post a healthy spread between its long and short positions--even though shorts might gain in value, they tend to significantly lag the longs.
In late 2016, AQR Style Premia Alternative QSPIX was upgraded to Silver after it had established a solid three-year track record. This strategy targets four well-established investment factors, also known as style premiums--value, momentum, carry, and defensive. Management buys securities (equities, bonds, commodities, and currencies) that exhibit these factor characteristics and shorts those that don't. Diversifying across these factors, which have a low correlation to one another, and across four asset classes, which also have low correlations to each other, should lead to more-robust performance than any of the factors or asset classes on their own. For the year to date through August, the fund returned 5.7%, placing it in the top quartile among funds in the multialternative category. Over the trailing three years, the fund returned 7.1% annualized, putting it in the top decile.
Managers of merger-arbitrage strategies need to assess the reason for a merger, the terms of the merger, any regulatory issues that may hinder the merger, and the likelihood of the merger actually occurring. Experience in analyzing deals is key, and Alex Graham, the portfolio manager of Bronze-rated Touchstone Merger ArbitrageTMGLX, has spent over 20 years focused exclusively on the merger-arbitrage space. The fund employs a risk-aware process and has a smaller asset base relative to some of the better-known mutual funds in this area. This allows the manager to invest in deals with smaller-cap targets, which is an advantage as they can provide more upside because they tend to exhibit wider spreads. Over the trailing three and five years, its performance was in the top quartile among market-neutral funds. And despite a challenging market environment characterized by narrower spreads, a weaker deal pipeline, and an uncertain regulatory environment, the fund generated meager but above-average category returns of 1.9% over the first eight months of 2017.
There is only one currency fund that Morningstar recommends--Eaton Vance Diversified Currency Income EIIMX, which is rated Bronze. One of the main reasons we like this fund is that it is more diversified than similar funds. Currently, the fund's largest exposures are the Serbian dinar at 7%, the Swedish krona at 5%, and the Czech koruna at 5%. This fund has generated above-average category returns over the trailing three and five years.