Swedroe: Why Alt Funds Underperform

May 02, 2016

The financial crisis of 2008, when all risky asset classes suffered dramatic losses, led many investors to seek out “alternative” investments that claimed to provide downside protection, or positive returns independent of the market environment. This resulted in the introduction of a new segment of mutual funds that operate at the intersection of traditional mutual funds and hedge funds.

These funds are frequently referred to as “liquid absolute return funds”—although they are marketed under many different names, such as total-return funds, go­anywhere funds or benchmark-free funds.

Do Absolute-Return Funds Work?

A common characteristic of all these funds is that, unlike hedge funds, they are registered as mutual funds. Thus, they tend to be more transparent, more liquid and less expensive than most hedge funds.

But the vital question is: Do they actually deliver on their “promise”? Joachim Klement—author of the study “The Cross-Section of Liquid Absolute Return Funds,” published in the winter 2015 issue of The Journal of Index Investing—provides the answer.

Klement investigated the performance of 15 different investment styles used in the liquid absolute-return-fund universe. The 15 categories were: aggressive allocation, absolute-return bond, cautious allocation, debt arbitrage, equity, equity-market neutral, event driven, flexible allocation, long/short debt, long/short equity, managed futures, moderate allocation, multicurrency, multistrategy and volatility.

To analyze their performance, Klement performed regressions of individual monthly fund returns for the traditional four factors of market beta, size, value and momentum. Because these funds can invest globally, he employed the international factors.

His data set, provided by Morningstar and Lipper, included a total of 1,140 mutual funds, globally, with a stated absolute-return target. Total assets under management were $464 billion. The data covered the period September 1994 through November 2014. The funds in the data set were generally very young, with a median age of just four to five years for most categories. And only 23% were in existence when the financial crisis hit.

Results

Following is a summary of Klement’s findings:

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