Alternatives Dispersion in Market Downturns

March 27, 2019

The fourth quarter of 2018 served as a significant period of market loss and investor drawdowns for a wide number of equity and aggressive strategies. December in particular saw record-setting outflows for active funds, extending across traditional and non-traditional funds. This volatile period saw particularly strong redemptions from products designed to see lower correlation with traditional markets. Alternative mutual funds faced a net flow rate of -7.4% in Q4’18 compared to -2.2% for International Equity and -0.6% for U.S. Equity. While multiple alternative strategies experienced less severe losses than broad traditional classifications, a significant concern for investors and advisors open to alternatives will be proper manager selection.

The tables below compare category level performance versus variability of returns. They show asset-weighted average returns and performance dispersion across leading alternative (as represented by SI objectives) and traditional strategies (captured in Morningstar categories). Blended equity mutual funds experienced double-digit losses in the fourth quarter; top and bottom quartile funds in those strategies were separated by two or three percentage points. Liquid alternatives conversely experienced wide divergences between top and bottom quartiles, like the private alternatives from which they derive many of their strategies. This is most strongly illustrated within classifications targeting similar markets and asset classes. The asset-weighted average return of Long/Short – Long-Biased funds (-13.0%) was in line with Large Blend funds for the quarter (-13.5%). Long/Short – Opportunistic funds meanwhile saw reduced, but still severe, losses at -7.8%. The differences in performance dispersion were much larger for liquid alternatives, as Large Blend saw a 2.4% gap compared to 5.7% for Long-Biased and 7.8% for Opportunistic funds. The increased flexibility for Opportunistic funds gave managers the ability to offer better downside protection while heightening the benefit to investors who chose top quintile funds.

Performance dispersion within alternatives places even greater importance on manager and fund selection.

Event-Driven and Equity Market Neutral experienced the greatest downside protection in the quarter at 0.2% and -1.7%, respectively, as measured by asset-weighted average returns. Those strategies were at the opposite ends of the dispersion spectrum in the quarter. Event-Driven saw an 8.6% gap between quartiles, the largest among alternatives, and Equity Market Neutral saw the narrowest difference. In both cases, this gap meant the difference between positive and negative performance.

An appeal of liquid alternative funds is their ability to offer diversification to a traditional portfolio. Behavior in the fourth quarter demonstrated that potential through reduced losses and the broad range of possible returns, while heightening the potential gains or losses from making the optimal choice. The importance of these choices remains high, even within a tighter market with a reduced fund count.

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