The recent (and long-awaited) return of market volatility has put alternatives back on the radar screen. But not only must investors familiarize themselves with the different types of alternatives that are available to them, they must also assess the skill level of the managers running these funds.

Manager Selection is Critical for Alternative Investors

Manager selection is a question that all investors face, of course, but it’s especially critical for investors in alternatives because these managers have greater freedom in their investment strategies. This freedom leads to a wide dispersion between the top-performing and below-average alt managers, and that dispersion is typically greater than what is found in traditional equity investments.

Comparing top and bottom managers

The below table examines the dispersion of returns for alternatives and traditional equities. For this example, alternatives are represented by the Morningstar Long-Short Equity Category. Traditional equity investments are represented by the Morningstar World Large Stock Category.

(We chose the latter category to represent a more “traditional” investment as it represents the type of long-only, large-cap strategies that most equity investors have exposure to.) The table examines the historical gap in performance between the top quartile and third quartile for each category.

After comparing these returns over three different periods, we can see the much wider range of returns in our alternatives example. Past performance is not a guarantee of future results. Alternative investments include private equity, managed futures, commodities and derivatives, while traditional investments generally refer to equities, bonds and cash.

Alternative investments can be less liquid and more volatile than traditional investments, such as stocks and bonds, and often lack longer-term track records. Investors should consider using financial advisors when making portfolio decisions.

Alternatives vs equities Top and bottom managers

Top performers are represented by the first quartile in the Morningstar category, with bottom performers represented by the third quartile. (The third quartile was used to remove the effect of outliers within the very worst performers.)

To determine quartiles, funds are ranked based on descending order of returns (best to worst). The first 25% of the funds are in the first quartile, the second 25% of funds are in the second quartile, the third 25% of returns are in the third quartile, and the last 25% are in the fourth quartile. Note that the return dispersion of other alternatives and equities categories may differ.

What might be causing the performance gap?

While the performance of any fund or security is never guaranteed and will fluctuate over time due to a wide variety of factors, we believe that there are two main reasons why there could be a wider performance gap in alternatives as compared to traditional investments:

1. Most alternative strategies aren’t tied to a traditional benchmark. In traditional long-only stock investing, the manager’s performance is typically benchmarked against the common index that best matches the long-only strategy. Furthermore, the index itself is comprised of a basket of individual stocks whose characteristics are consistent with that of a particular category.

When investing, many managers will primarily invest among the stocks that make up the index, overweighting those stocks they believe will outperform and underweighting the ones they believe will underperform. As a result, performance tends to generally track the index, with the managers’ active weighting decisions contributing to outperformance or underperformance.

Like traditional long-only indexes, alternative investments have various performance indexes that seek to measure performance for various strategies (e.g. Long/Short, Global Macro, Market Neutral, etc.). Alternative indexes, however, differ from traditional indexes in that the index is typically an average of manager performance (as opposed to being comprised of a basket of underlying stocks).

As a result, alternative managers have more freedom to define and pursue their own investment objectives (within the parameters of the fund prospectus). Such objectives tend to vary widely across managers, even among those using the same strategy. The pursuit of widely differing investment objectives understandably leads to a wide dispersion of returns across alternative managers.

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