Liquid Alternatives Challenges and Opportunities

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Owen Ramsey
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Liquid Alternatives Challenges and Opportunities Tayfun Icten Multi-Asset and

2 12/1/2003 4/1/2004 8/1/ /1/2004 4/1/2005 8/1/ /1/2005 4/1/2006 8/1/ /1/2006 4/1/2007 8/1/ /1/2007 4/1/2008 8/1/ /1/2008 4/1/2009 8/1/ /1/2009 4/1/2010 8/1/ /1/2010 4/1/2011 8/1/ /1/2011 4/1/2012 8/1/ /1/2012 4/1/2013 8/1/ /1/2013 4/1/2014 8/1/ /1/2014 4/1/2015 8/1/ /1/2015 4/1/2016 8/1/ /1/2016 4/1/2017 8/1/2017 Rates Matter for Alternatives Hedge Fund Index Returns vs. U.S. 10-Year Yield (15-Year Window) 14.0% 6.0% 12.0% 5.0% 10.0% 4.0% 8.0% 3.0% 6.0% 2.0% 4.0% 2.0% 1.0% 0.0% 0.0% 2 Source: Morningstar HF Return - Left Axis 10-Year Yield - Right Axis

3 12/2003 4/2004 8/ /2004 4/2005 8/ /2005 4/2006 8/ /2006 4/2007 8/ /2007 4/2008 8/ /2008 4/2009 8/ /2009 4/2010 8/ /2010 4/2011 8/ /2011 4/2012 8/ /2012 4/2013 8/ /2013 4/2014 8/ /2014 4/2015 8/ /2015 4/2016 8/ /2016 4/2017 8/2017 Long-Term Returns Have Eroded 60/40 Portfolio vs. Credit Suisse Hedge Fund Index 14% 12% 10% 8% 6% 4% 2% 0% 3 HF 10 YR Roll 60/40 10 YR Rolling Return

4 Liquid Alternative Mutual Funds Continue to Grow Despite the weakness in long-term returns, liquid alts have experienced reasonable growth. 250,000,000, ,000,000,000 $ Billions 150,000,000, ,000,000,000 Total Net Assets 50,000,000,

5 Some Alternatives Have Grown Faster Than Others Asset Growth by Morningstar Category 60,000,000,000 50,000,000,000 40,000,000,000 $ Billions 30,000,000,000 20,000,000,000 Long Short Credit Long Short Equity Managed Futures Market Neutral Multialternative Multicurrency Options-Based 10,000,000,

6 Some Alternatives Categories Are Seeing Outflows Estimated net flows, organic growth, and total assets as of January Organic Growth Rate % (TTM) Total Assets ($Bil) Morningstar Category 1-Mo QTD YTD 1-Yr US Fund Multialternative 1,083 1,083 1,083 2, US Fund Long-Short Equity , US Fund Managed Futures (116) (116) (116) (2,162) (8.52) 25 US Fund Market Neutral US Fund Options-Based , US Fund Long-Short Credit (8) (8) (8) (480) (6.26) 7 US Fund Multicurrency (14) (14) (14) Copyright 2018 Morningstar, Inc. 6

7 Performance Improves for Alts Categories in 2017, With Some Unexpected Results in 2018 Name 2017 Perf. 3 Year Ann. 5 year Ann. 5-Year Beta to 60/40 5 Year Beta to SPX Recent Sell-Off Jan 26th to Feb 8 5-year Sharpe 25-Year Sharpe 60% AGG- 40% VTI 10.4% 6.2% 7.3% % 1.63 US Fund Long-Short Equity 11.2% 5.8% 6.2% % US Fund Options-Based 9.1% 5.4% 5.2% % US Fund Multialternative 5.1% 2.0% 2.6% % 0.50 US Fund Managed Futures 3.0% 0.1% 3.8% % 0.25 US Fund Long-Short Credit 2.4% 1.7% 1.5% % 0.44 US Fund Market Neutral 2.4% 1.1% 1.2% % US Fund Multicurrency 0.8% 0.5% -0.5% % SPDR S&P 500 ETF 21.7% 14.5% 15.8% % Average Beta

8 Alternatives Provided Some Downside Protection From Peak to Trough Alts category returns versus major asset-class performance Name Recent Market Turbulence from Jan 26 to Feb 8 CBOE Market Volatility (VIX) US Dollar 1.3% US Fund Multicurrency -0.4% ishares 3-7 Year Treasury Bond ETF -0.4% US Fund Long-Short Credit -0.9% BBgBarc US Agg Bond TR USD -1.0% US Fund Market Neutral -1.4% BBgBarc High Yield Corporate TR USD -1.4% SPDR Gold Shares -2.8% US Fund Multialternative -4.0% US Fund Long-Short Equity -6.3% United States Oil -7.5% US Fund Options-based -8.1% US Fund Managed Futures -8.6% ishares MSCI Emerging Markets ETF -8.6% ishares Edge MSCI Min Vol USA ETF -9.1% S&P 500 TR USD -10.1% NASDAQ 100 TR USD -10.2% ishares Edge MSCI USA Value Fac tor ETF -10.2% ishares Edge MSCI USA Momentum Fc tr -10.3% SG Trend Index -11.9% Average Alts Category Performance -4.2% 8

9 Multialternative: Category Considerations and Medalist Performance (3-Year period ending January 2018) Category Considerations Roughly 0.3 average beta Most heterogeneous Global-macro return drivers Style-premium return drivers Other alternative betas Asset-allocation models Traditional fundamental long-short Hedge fund replication products Macro investing struggles Illiquidity and credit concerns Name Morningstar 3-Year Ann. Analyst Rating Return AQR Style Premia Alternative I Silver 7.6% Goldman Sachs Absolute Ret Trckr Instl Bronze 4.6% AQR Style Premia Alternative LV R6 Silver 4.4% Litman Gregory Masters Alt Strats Instl Bronze 3.6% AQR Multi-Strategy Alternative I Bronze 3.4% Principal Global Multi-Strategy Instl Bronze 3.2% WCM Alternatives Event-Driven Instl Bronze 2.5% GMO SGM Major Markets III Bronze 2.1% Dreyfus Global Real Return I Silver 1.7% JHancock Global Absolute Ret Strats NAV Bronze 0.9% William Blair Macro Allocation I Bronze 0.5% Multialternative Category Average 2.0% Morningstar Medalist Average 3.1% 9

10 Long-Short Equity: Category Considerations and Medalist Performance (3-Year period ending January 2018) Category Considerations Average beta 0.5 Pure company-specific risk Factor-based risk premia Risks other than single stock specific Often downside protection in mind Seek market dislocation Name Morningstar Analyst Rating 3-Year Ann. Return AQR Long-Short Equity I Bronze Boston Partners Long/Short Equity Instl Bronze 9.82 Schwab Hedged Equity Bronze 8.34 Diamond Hill Long-Short I Bronze 7.47 Boston Partners Long/Short Rsrch Instl Silver 7.24 Boston Partners Global Long/Short Instl Bronze 6.38 Long-Short Equity Category Average 5.8% Morningstar Medalist Average 9.2% 10

11 Market Neutral: Category Considerations and Medalist Performance (3-Year period ending January 2018) Category Considerations Zero beta Factor long-short Merger spreads and deal volume Multiple dimensions in neutrality Low short rates are not good Subject to factor crash risk Leverage Name Morningstar Analyst Rating 3-year Ann. Return AQR Equity Market Neutral I Bronze 9.4% AQR Diversified Arbitrage I Bronze 2.9% Touchstone Merger Arbitrage Instl Bronze 2.7% AC Alternatives Market Neutral Val I Bronze 2.5% Arbitrage I Bronze 2.5% Merger Institutional Bronze 2.3% BlackRock Global Long/Short Equity Instl Bronze 1.3% Vanguard Market Neutral I Silver 1.2% Market-Neutral Category Average 1.1% Morningstar Medalist Average 3.1% 11

12 Managed Futures: Category Considerations and Medalist Performance (3-Year period ending January 2018) Category Considerations Zero beta with some spikes Systematic trend-followers dominate Time series momentum Volatile periods and max drawdown Margined derivative accounts, but not short vega Not a 100% hedge Must understand margin/equity ratio Name Morningstar Analyst Rating 3-Year Ann. Return American Beacon AHL Mgd Futs Strat Instl Bronze 2.2% Credit Suisse Managed Futs Strat I Bronze 1.2% Natixis ASG Managed Futures Strategy Y Bronze -0.5% Abbey Capital Futures Strategy I Bronze -0.5% AQR Managed Futures Strategy I Bronze -2.8% AQR Managed Futures Strategy HV I Bronze -4.9% Managed-Futures Category Average 0.1% Morningstar Medalist Average -0.9% 12

13 Options-Based: Category Considerations and Medalist Performance (3-Year period ending January 2018) Category Considerations Market beta ranges from -0.5 to 1.0 Systematic outcome-based strategies make up the core Consistent options-based strategies for qualification Very large dispersion year to date Watch for naked option sellers/tail risks!!! Look at daily returns! Similar to credit-sensitive bonds If you must, keep it small Name Morningstar Analyst Rating 3-year Ann. Return JPMorgan Hedged Equity I Silver 7.7% Gateway Y Silver 6.7% Swan Defined Risk I Bronze 4.7% AllianzGI Structured Return P Bronze 4.5% Options-Based Category Average 5.4% Morningstar Medalist Average 5.9% 13

14 Credit Long-Short and Multicurrency: Category Considerations Credit Long-Short Strategy No Morningstar Medalists here Duration-neutral portfolios, spread assets, and static hedges Compressed credit spreads, no external leverage Beware of derivatives and structured products internal leverage After a major credit dislocation, these funds may provide better value Small doses to add cash plus yield, but tail risks may be hidden Multicurrency Highly heterogeneous The core is the carry trade, a globalmacro risk factor Invest in higher-yielding currencies against the U.S. dollar High correlation to equities Other players may be net long or short the U.S. dollar 14

15 Alternatives Charge More Than Double for Institutional Share Classes 15 Calculated Average Net Expense Ratio Distribution Category Median Calculated Average Net Expense Ratio Distribution Category Median Distribution Group - Alternatives Distribution Group - Traditional Equity Alternative Defer Load Small Cap Deferred Load Equity Alternative Front Load Small Cap Front Load Equity Alternative Institutional Small Cap Institutional Equity Alternative Level Load Small Cap Level Load Equity Alternative No Load Small Cap No Load Equity Alternative Retirement, Large Small Cap Retirement, Large Equity Alternative Retirement, Medium Small Cap Retirement, Medium Equity Alternative Retirement, Small Small Cap Retirement, Small Managed Futures Defer Load Intermediate-Term Bond Deferred Load Managed Futures Front Load Intermediate-Term Bond Front Load Managed Futures Institutional Intermediate-Term Bond Institutional Managed Futures Level Load Intermediate-Term Bond Level Load Managed Futures No Load Intermediate-Term Bond No Load Managed Futures Retirement, Large Intermediate-Term Bond Retirement, Large Managed Futures Retirement, Medium Intermediate-Term Bond Retirement, Medium Multialternative Defer Load Intermediate-Term Bond Retirement, Small Multialternative Front Load Large Cap Deferred Load Multialternative Institutional Large Cap Front Load Multialternative Level Load Large Cap Institutional Multialternative No Load Large Cap Level Load Multialternative Retirement, Large Large Cap No Load Multialternative Retirement, Medium Large Cap Retirement, Large Multialternative Retirement, Small Large Cap Retirement, Medium Large Cap Retirement, Small Institutional Average Front Load (Class A) Level Load (Class C)

16 Morningstar Fee Study Results Alternatives Fund Fees Have Gone Up 16

17 Share-Class-Related Flows (All Mutual Funds) Morningstar Direct Flows Data 17 All Share Class Types Name 1-Yr (Mil) Mkt Sh% Jan 2018 Mkt Sh% Jan 2017 Inst 328, Other 231, A (225,580) No Load (133,216) Retirement 170, Inv (28,249) C (70,992) Adv 3, S (7,154) D (1,116) N (1,362) B 20, M (4,308) Unclassified (312) T (2,530) Copyright 2018 Morningstar, Inc.

18 Concluding Remarks Rates matter for alternatives. Lower yields on cash holdings (managed futures, merger-arbitrage, credit long-short). Compressed credit spreads, option premiums, and overall risk premiums. More dislocations and more opportunities for alternative funds? Capacity-related considerations. Consolidation is not good for alternatives. The battle of bots versus humans. Increasing quantitative equity investing, alternative data, natural language processing. Overcrowding effects, Quant Quake of August A mix of traditional versus quantitative? Options-based strategies are complex, perhaps some are too complex!!! Be wary of naked option sellers. Time to be mindful of stock and bond correlations as rising rates can destabilize certain markets. Some alternative strategies may help. And finally, most alternatives are still too expensive for what they deliver. 18

19 Disclosures 2018 Morningstar, Inc. All rights reserved. For information and/or illustrative purposes only. Not for public distribution. Reproduction, transcription or other use by any means, in whole or in part, without the prior written consent of Morningstar, Inc. is prohibited. The Morningstar name and logo are registered trademarks of Morningstar, Inc. This presentation is for investment professional use only. The analyst identified on the cover page is employed by Morningstar Research Services LLC, a wholly-owned subsidiary of Morningstar, Inc. The information, data, and opinions presented herein are provided solely for informational purposes and are not warranted to be correct, complete or accurate. The opinions expressed within are given in good faith, are as of the date of the presentation, are not statements of fact, are subject to change and in certain instances are those of the presenter. Except as otherwise required by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. Morningstar Analyst Ratings are subjective in nature and should not be used as the sole basis for investment decisions. Morningstar Analyst Ratings are based on Morningstar s Manager Research Group s current expectations about future events and therefore involve unknown risks and uncertainties that may cause such expectations not to occur or to differ significantly from what was expected. Analyst Ratings are not guarantees nor should they be viewed as an assessment of a fund s or the fund s underlying securities creditworthiness. Investments in securities are subject to market and other risks and there is no assurance or guarantee that the investment objectives of the security will be achieved. Past performance of securities assigned a Morningstar Analyst Rating may or may not be sustained in the future and should not be viewed as an indication of its future performance. Investment returns fluctuate so that investment performance noted herein may be lower or higher than what is being experienced currently. Morningstar s Manager Research Group refers to a group of wholly-owned subsidiaries of Morningstar, Inc. (including but not limited to, Morningstar Research Services LLC) that produce investment analysis and opinions on mutual funds, exchange-traded funds and collective investment schemes. 19

An Alternative to Rescue the Middle Class Fund Family

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