Swedroe: Why Alt Funds Underperform

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:

• A substantial portion of the variation in fund returns can be explained through the traditional four factors. For the equity-related categories, the R² (the measure of how well the factors explain the performance of the fund) of the regressions is, on average, greater than 0.6. Klement noted this finding was consistent with prior research.
• Funds that do not employ traditional hedge fund strategies showed even higher adjusted R² values.
• After correcting for different systematic factor exposures, the monthly alpha for all categories of liquid absolute-return funds is negative, ranging from -0.13% to -1.03%, and in most cases, is statistically significant. Only the alphas of the aggressive allocation funds, debt arbitrage funds, absolute-return equity funds and managed futures funds are not statistically significant.
• In most cases, a very low percentage (less than 10%) of funds in a category showed positive alphas. In no case did more than about one-third of funds show positive alphas.
• Klement ran a second series of regressions that included nine factors in order to identify systematic exposure of liquid absolute-return funds to other asset classes. These other factors were: interest rates, credit spreads, volatility of stock prices, commodities and currencies. He found that the majority of the variation in the monthly returns of liquid absolute-return funds was explained by systematic factor exposures. Except for the managed futures funds, the R² of regressions is on average greater than 0.5.
• Equity-related absolute-return funds have a statistically and economically significant exposure to the overall stock market. Bond-related categories, like absolute-return bond funds, show a significant exposure to interest rates and credit spreads.
• All absolute-return fund categories show a statistically and economically significant exposure to the overall stock market factor, with stock market betas typically on the order of 0.4 to 0.8. This indicates that although these funds try to reduce systematic variation with the stock market, they still are far from uncorrelated with the stock market.
• The positive exposure to equity markets suggests that all of these liquid absolute-return funds might experience low or even negative returns in times of declining stock markets. Thus, there’s nothing absolute about their returns.
• The cost of liquid absolute-return fund investments tends to be rather high. Median expense ratios were 1.2% to 2.2% depending on the category, and some fund expenses reached as high as 8.7%.
• Though the results weren’t statistically significant, the data showed that fund returns were negatively correlated with both assets under management and expense ratios (a finding that is consistent with prior literature).

Importantly, Klement found that although these liquid absolute-return funds do not invest in equities directly, they do gain exposure to equity market risks indirectly, through investments that are correlated with the overall equity market. He concluded: “Liquid absolute return funds face problems similar to those of traditional mutual funds. At the same time, the use of leverage and short positions introduces risks similar to those of hedge funds to these mutual funds, all in the hope of better performance in market downturns.” Unfortunately, there’s no evidence to support that hope.

Conclusion

The bottom line is that the research continues to show that investors are, in general, best served by investing in more traditional investments. However, if you do decide to invest in alternatives, you should only consider funds that provide systematic exposure (so you know it’s replicable) to well-known factors that the research shows have the following characteristics regarding their premiums:

• Persistence—It holds across long periods of time and various economic regimes.
• Pervasive—It holds across countries, regions, sectors and even asset classes.
• Robust—It holds for various definitions (for example, there’s a value premium whether it’s measured by value by price-to-book, earnings, cash flow or sales).
• Investable—It holds up not just on paper, but after considering trading costs.
• Intuitive—There are logical risk-based (economic) or behavioral-based explanations for the premium and why it should continue to exist.
• It isn’t subsumed by other well-known factors.

While there are more than 300 factors in what John Cochrane once called the “factor zoo,” only a few meet the preceding criteria. These factors include beta, size, value, momentum, profitability/quality, volatility and the carry trade.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.