Liquid alternative mutual funds and exchange-traded funds (ETFs) have been heavily marketed to financial advisors for several years now. With the volatile stock market conditions we saw in August of 2015 and now to start off 2016 they are being pitched to advisors as an answer to market volatility and as assets with low correlations to stocks and bonds.

A recent article in Investment News highlights this: “And during the past 12 months, that pitch has hit home with investors and advisors: Liquid alt funds have been flying off the shelves. Investors poured a net $10.7 billion into such funds at the same time they sold a net $108 billion worth of U.S. stock funds, according to Morningstar, Inc.” (For more, see: Why Alternatives via Wirehouses Are Growing.)

This all sounds good, but how have liquid alts performed during volatile stock markets?

Performance in 2016

Through Feb. 19, 2016 the S&P 500 was down 5.85% year-to-date. By comparison here’s how five major categories of liquid alternative funds have performed according to Morningstar:

Bear Market Funds: 11.03%

Managed Futures: 3.77%

Market Neutral: -0.35%

Multi Alternative: -2.43%

Long/Short Equity: -4.26%

Bear market funds, of course, are designed to thrive when the stock market is dropping. Their track record is dismal with the average fund having lost 15.96% over the past five years. These funds are clearly for market timers. All five of these main alternative categories have outperformed the S&P 500 so far in 2016 to one degree or another. (For more, see: Do Bear Market Funds Make Sense for Investors?)

Volatility and Correlation

Standard deviation, a measure of the variability of return and one proxy for risk, for the S&P 500 index for the trailing five years ending Jan. 31, 2016 was +/-11.98%. By comparison, the standard deviation for these categories of alternative funds was:

Bear Market Funds: +/-19.22%

Managed Futures: +/- 8.77%

Market Neutral: +/-4.33%

Multi Alternative: +/-5.80%

Long/Short Equity: +/-8.78%

Correlation to the stock market is another consideration. One measure is R-squared. The five-year R-squared ratios are:

Bear Market Funds: 82.67%

Managed Futures: 47.80%

Long-Short Equity: 65.27%

Note: Morningstar used benchmarks other than the S&P 500 for the market neutral and multi alternative categories. (For more, see: Alternative Investments: A Look at the Pros & Cons.)

Manager Selection Critical

The risk and return numbers mentioned above are of course for broad categories. In choosing a liquid alt strategy it is important to select a fund and a manager that delivers value. The range of returns so far in 2016 across the spectrum of alternative funds has been broad.

According to Morningstar, returns among long-short equity funds have ranged from a gain of 8.93% to a loss of 22.25%. Clearly financial advisors looking to use alternatives to dampen risk in client portfolios need to understand alternative strategies that they are considering and if they will provide the benefits they are seeking. (For more, see: A Look at Vanguard's Liquid Alts.)

According to another recent article by Investment News, market environments like the current one really show off the talents of top alternative managers. The article points out that the dislocation in performance among the sectors and asset classes of the stocks that comprise the S&P 500 is now higher than at any time since the period leading up to the financial crisis.

Some Examples

The top long-short equity fund year-to-date with a five-year track record is the Guggenheim Alpha Opportunity Institutional (SAOIX), according to Morningstar. Through February 19, 2016 the fund gained 4.71% for the year and had an average annual return of 9.66% over the trailing five years. This is just below the 9.71% average annual return for the S&P 500 Index for the same period. The fund’s five-year R-squared ratio to the S&P 500 for the five years ended Jan. 31, 2016 is 67.79%, just above the category average of 65.27%.

The Guggenheim managers have delivered index tracking returns over the five-year period and beaten the index handily in 2016’s down market so far. However, in the case of this fund, this performance has come with a degree of volatility as the fund’s standard deviation over the trailing five years is +/-14.43% versus +/-11.98% for the S&P 500. (For more, see: Alternative Investments: Financial Advisor Client Guide.)

Gateway Fund (GTEYX) is another example of a solid fund in the long-short equity category. The fund’s trailing five-year return is an average of 3.48% placing in the category’s 41st percentile. It’s R-squared ratio is much higher at 87.24% but its standard deviation is less than half that of the S&P 500 at +/-4.52% for the trailing five years. Moreover, the fund has not had a losing year since 2008. However the fund is down 2.96% or about half the loss of the S&P 500.

The Bottom Line

The answer to the question of whether liquid alternative funds and ETFs have delivered both in this volatile stock market and over time is that is depends. Financial advisors and investors need to make this evaluation on a strategy by strategy and manager by manager basis. (For more, see: Investing in Alternative Mutual Funds and ETFs.)

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