A look at where liquid alternative funds fall in the alternatives style box and what it means for investors.
We recently introduced the Morningstar Style Box for alternative funds, a new research framework for evaluating liquid alternatives investments that’s available to Morningstar Direct clients at the end of October and will be on the Morningstar website in early 2018.
We first introduced this style box last year in an article that showed how its main components of correlation and volatility can help investors quickly and intuitively gauge a fund's diversification potential. Alternative strategies come in many different varieties, and funds within the same Morningstar Category that pursue very similar strategies can still have very different diversification characteristics.
In this follow-up, we illustrate these features by examining funds that fall into the four corners of the alternatives style box. This article will focus on two corners of the box, and tomorrow we will tackle the other two. For reference, the exhibit below shows where all liquid alt funds fall in the alternatives style box as of July 2017.
Alternative Funds With High Correlation and Low Relative Volatility
In the top left region of the alternatives style box, one finds funds that have a high correlation to global equities (above 0.50 during the trailing three years) and a low relative volatility (less than 33% the volatility of global stocks when measured by monthly standard deviation during the trailing three years). Exhibit 2 shows the breakdown of funds by category as of July 2017.
Highly correlated, less-volatile alternative funds are often considered a partial stand-in for fixed income, which has a similar risk/reward profile. For the measurement period in this example, the Bloomberg Barclays U.S. Aggregate Bond Index had 27% of the relative volatility of global equities, for instance.
These funds' high correlation to equities should give investors pause, as it indicates performance tends to be influenced by the direction of global stocks. In a market where stocks are falling, these strategies are likely to fall as well, albeit by less given their lower relative volatility. Still, investors who have turned to these funds in lieu of fixed income amid concern about rising interest rates should keep in mind that they could disappoint in an equity market sell-off, during which it's not uncommon for bonds to rally. In such a scenario, they'd probably be better off in bond funds.