A look at where liquid alternative funds fall in the alternatives style box and what it means for investors, ghouls, and ghosts.
We recently introduced the Morningstar Style Box for alternative funds, a new research framework for evaluating liquid alternatives investments. It is available to Morningstar Direct clients at the end of October and will be on the Morningstar.com site 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 varieties, and funds within the same Morningstar Category that pursue very similar strategies can still have very different diversification characteristics.
In this followup, we illustrate these features by examining funds that fall into the four corners of the alternatives style box. Yesterday, we focused on the two top corners of the style box. This article will focus on the bottom two corners. For reference, the exhibit below shows where all liquid alt funds fell in the alternatives style box as of July 2017.
Alternative Funds With Negative Correlation and High Relative Volatility
The bottom right corner of the style box is composed of alternative funds that have exhibited a lower (in this case, negative) correlation to global equities and higher (at least two thirds that of the index) volatility over the trailing three-year period.
Although the style box's rightmost border ends at a relative volatility of 1--where a fund's volatility is equal to that of global equity markets--in practice some managed futures, multialternative, and long-short equity funds can be more volatile than global equities over a three-year period (we plot those funds on the style box's border).
Most of the funds that fall into the lower right corner of the alternatives style box are classified in the managed-futures category. Other strategies, like Hussman Strategic Growth HSGFX, which has been net short equities via written options because the manager thinks the stock market's valuation is unsustainable, can also end up in this corner of the style box. Exhibit 2 shows the category breakdown.
While having a low or negative correlation to stocks may seem like a desirable characteristic in an alternative fund, because it shows the fund is being driven by different risk factors than equities, it is important that investors understand why a fund has acted like it has. Managed-futures funds look to profit from trends across multiple asset classes. To follow trends, managed-futures funds use futures contracts. Futures typically require a small amount of capital to be held as collateral so the funds can have higher notional leverage than strategies that rely on physical securities. Essentially, they bet that winners will keep winning and losers will keep losing. The potential to benefit from assets falling in value, like oil in late 2014 or stocks during the financial crisis, contributes to the strategy's low and sometimes negative correlation to global stocks.