Alternative Observer - Morningstar

Commodities: Just Another Asset Class, or Alternative Investments? continuedhas surely progressed as investor awarenessand investment vehicle accessibility hasdramatically increased.The EvidenceThe evidence indicates that most investors,no matter what their sophistication level,believe that commodities are alternativeinvestments. As the sophistication levelincreases, however, so changes the viewpointon commodities.First, we’ll start with the very leastsophisticated of investors, retail investors intarget-date mutual funds. In 2006, theDepartment of Labor designated target-datefunds “Qualified Default InvestmentAlternatives” to cash or money market vehiclesin retirement accounts. The theory wasthat many retail investors would never reachtheir retirement goals, as their retirementaccount assets too often sat in cash (thedefault option in many retirement plans).By changing the default option to a diversifiedportfolio that progresses over time(theoretically getting less risky as retirementapproaches), unsophisticated retailinvestors would at least have a chance atfunding their retirement needs.Most target-date funds consist of stocks andbonds. Per Morningstar’s 2011 industrysurvey of target-date series funds3, however, afew of the largest 21 target-date fund familieshave recently branched into commodities.Five allocated to long-only commodity-futuresbased strategies, in the range of 5.9%–9.4%,while six families allocated to long-onlyequity-based commodity strategies in the rangeof 2.8%–5.8%. These investments wereconsidered “alternative” by the fund families,as supported by their small allocations.34Next, we’ll look at advisors and institutions.As part of the 2011 Morningstar/Barron’sAlternative Investment Survey, we askedinstitutional investors and advisors:Are commodities alternative investments?Sixty-six percent of institutions and 78%of advisors responded “yes.” Clearly, bothgroups lean toward classifying commodities asalternatives. But the free responses (to thequestions, “How are you gaining exposure?”and “What strategies are you employing?”)demonstrated varying opinions at varyinglevels of sophistication. (If you missedthe survey, feel free to send your comments to:nadia.papagiannis@morningstar.com).Morningstar Alternative Investments ObserverFirst Quarter 2012ConclusionSo, it appears that all forms of commodityinvesting are still considered alternativeby many investors, including both institutionsand advisors. It appears, however, thatboth types of investors are becoming moresophisticated and looking to long-short tradingstrategies as a means of obtaining alternativecommodity exposure, rather than standardlong-only investing. In a few years’ time, theviews on commodities as alternativeinvestments will undoubtedly change. KInstitutions that believe commodities arealternative primarily gain access tocommodities through futures-tracking ETFs.But about 25% of the “yes” respondentsinvested in some sort of long-shortcommodities strategy, while a small percentageeven invested directly in commoditiessuch as farmland or timberland. Thoseinstitutions that do not believe commodities tobe alternative investments primarilyresponded that they do invest in commoditiesbut consider it a core allocation.Advisors’ responses indicated a slightly lowerlevel of sophistication. Those agreeingthat commodities are alternative primarilygained access to commodities throughfutures-based ETFs, similar to institutions.About 22% of the yea-sayers also indicatedthat they invested in long-short commoditystrategies. Some advisors, however, arestill gaining access to commodities primarilythrough equities. Furthermore, many ofthe advisors who do not believe commoditiesare alternatives simply did not invest incommodities at all.Morningstar Target-Date Series Research Paper: 2011 Industry Survey. search2011.pdf

5Morningstar Alternative Investments ObserverFirst Quarter 2012Quant Corner: The Euro IsAlready DeadAsset allocators can no longer look to the euroas the basis for a risk-free asset.byPaul D. Kaplan, Ph.D., CFAQuantitative Research Director,Morningstar EuropeOne of the most basic considerations for anyinvestors considering the asset allocationof their portfolio is how to divide their portfoliobetween risk-free and risky assets. However,this raises the question: What is a risk-freeasset? While there is no simple answer to thisquestion, financial economics has alwaysheld that since government-issued debt isgenerally free of default risk, it is a reasonableproxy for a risk-free asset so long as investorseliminate interest-rate risk by matchingthe duration of the government bond with theirinvestment horizon.In the modern era, in most developedeconomies, and in many emerging economies,the default-free ideal was realized by theemergence of pure fiat national currencies. Thissystem gives each national governmentvirtually unlimited power to issue debt, whichthe bond markets regard as virtually freeof default risk. This is because each nationalgovernment has the power to persuadeits central bank to increase the money supplyand so devalue its debt with respect to theprices of goods and services. Even thesupposedly independent Fed acquiesced to U.S.fiscal policy in the 1960s and 1970s, leadingto the highest rate of U.S. inflation in the20th century and a prolonged decline in thevalues of U.S. government bonds.Until the introduction of the euro, eachEuropean country had both its own monetaryand fiscal policy, resulting in a wide varietyof inflation rates and government-bond yieldsacross the continent. The promise of theeuro was to bring uniformity to inflation andinterest rates across the eurozone withouta corresponding convergence of fiscal policy.Criticisms of the scheme were dismissedin a drive to bring about monetary union atwhat was considered a unique historicalopportunity to do so.The plan for the single currency was agreedupon with the signing of the MaastrichtTreaty on Feb. 7, 1992, resulting in the launchof the common currency and the new monetaryauthority, the European Central Bank, onJan. 1, 1999.Until 2009, the euro seemed to deliver itspromise. As Exhibit 1 (next page) shows, fromearly 1992, when the Maastricht Treaty wassigned, until the end of 1998, government-bondyields converged as predicted. Then until 2009,they remained virtually the same.However, within the apparent successof the single currency lay the cause of itsown demise. Specifically, because thegovernments of the poorer countries were ableto borrow at the same rate as the richercountries, in effect the governments of thepoorer countries came to be subsidizedby the richer countries. A basic law ofeconomics is that if you subsidize an activityyou get more of it, and because the poorercountries were able to borrow and spend atsubsidized interest rates, they did just that.This became an issue most particularly for theGreek government, which has always haddifficultly collecting taxes from its citizens.The late economist Herbert Stein famouslystated that “if something cannot goon forever, it will stop.” The unity of eurozonegovernment-bond yields was certainlysubject to this law and, as Exhibit 1 shows, didindeed stop in 2009. Eventually realityemerged in the bond markets that countrieswith conflicting fiscal policies cannot havethe same government-bond yields. However,there is an important difference betweenthe diversity of yields before the euro era andthose of today. In the past, differencesof yields were largely due to differences in therates of inflation across countries thatwere rooted in differences in monetary policy.Because today the poorer eurozonegovernments cannot set their own monetarypolicies, the only option that they have is toC ON T I N UE D ON N E X T PAGE

6Quant Corner: The Euro Is Already Dead continuedMorningstar Alternative Investments ObserverFirst Quarter 2012YieldExhibit 1: Long-Term Government-Bond Yields for Selected Eurozone 0701-0801-0901-1001-1101-12Sources: Morningstar EnCorr, International Monetary Funddefault (which the Greek government hasalready effectively done, albeit not yet inname). Hence, the differences in yield are nowdue to differences in default probabilities.What this means for investors is that theycannot lump all eurozone government debt intoa single asset class. It is now more importantthan ever to look at each government’screditworthiness on its own merit. Fortunately,the bond markets are already doing thisso that investors can use yield spreads asguides as to which country’s debt they canregard as “risk-free” and which ones are risky.And they can do this without the aid of thesovereign credit ratings that have proved tobe irrelevant.There is much debate about the future of theeuro. At the 2012 Morningstar InvestmentConference in Vienna, two leading experts tookopposite points of view. Professor PeterBofinger of University of Wurzburg argued thatthe euro would survive, while Professor AndrewClare of Cass Business School in Londonargued that it must ultimately at least partiallyunravel. What was interesting was thatthese two economists agreed on the economicsof the eurozone. Namely, they agreed thatwithout some sort of fiscal union, the eurocannot continue in its current form. The sourceof their differences lies in their politicaloutlook, with Professor Bofinger arguing thatthe politicians will agree to a fiscal union whileProfessor Clare argued that voters of thevarious European countries would never acceptsuch a loss of national sovereignty.We can understand the underlying economicproblem of the eurozone by referringto the theory of “optimal currency zones” asarticulated by Nobel Prize-winning economistRobert Mundell. According to Mundell, in orderfor it to be optimal for a group of countries tohave a single currency, the following conditionsmust hold:1 There must be labor mobility so that peopleare willing and able to relocate throughoutthe zone to access jobs.2 There must capital mobility across the zone.3 The countries within the zone must havesimilar business cycles.4 There must be a risk-sharing system in placeacross the zone so that money can beredistributed geographically when necessary.What is striking about the eurozone is theabsence of these conditions, thus making itclear that the creation of the euro wasmotivated by politics rather than economics.Whatever the politicians may or may not do tosave the euro, what is most importantto investors are the choices that they now faceacross the investment landscape. What isapparent from the sovereign-bond yield curvesis that while the euro might still exist asthe common medium of exchange across thezone, it has ceased to exist as the basisfor a pan-European risk-free asset. As far asasset allocation is concerned, the euro isalready dead. K

7Morningstar Alternative Investments ObserverFirst Quarter 2012Morningstar ProductSpotlight:Morningstar OfficeAnalyzing alternative investments inMorningstar Office.SMbyJosh CharneyAlternative Investment AnalystMorningstar Office provides advisors with apowerful portfolio-tracking tool and theability to produce data-rich reports in aclient-friendly format. Yet, far too few advisorshave time to venture outside their dailykeystrokes and miss out on the software’sin-depth research capabilities. One area whereadvisors could brush up is in alternativeinvestments, as there is a swath of productsavailable but few places to turn to forreliable research. (Morningstar recentlylaunched an educational website for lternative-investments.htm.) In this article, weshowcase how Morningstar Office canbe used to gain valuable insight into the worldof alternative investments.SMOffice as a Screening ToolTo start the search in the research module,we entered the seven open-endedalternative categories, which are: bear market,currency, long/short equity, managedfutures, market neutral, multialternative,and nontraditional bond. (See Exhibit 1.)We limited this search to only mutual funds,but the alternative exchange-traded fundcategories are the same as the ones listed,plus: volatility, trading-miscellaneous, tradingleveraged equity, trading-leverage debt, andtrading-inverse commodities.The search criteria below can be used to screenfor alternative mutual funds rated 4 starsand above and open to investors. When runningthe screen, it’s important to place commasto separate the “or” from the “and” blocks andto eliminate multiple share classes.The search produces 17 results across the long/short, market-neutral, multialternative, andnon-traditional-bond categories. Currency andmanaged-futures funds lack star ratingsbecause of short track records and not enoughExhibit 1: Alternative Mutual Fund Searchconstituents. (At this time, Morningstardoes not intend to rate bear-market funds, asmost of the funds in the category areindex-based.) If advisors seek a fund in one ofthese categories, they can eliminate theMorningstar Rating screen and instead screenon other factors. Other factors we canadd to this search include assets undermanagement of more than 100 million (fieldname: fund size) or a track record of atleast four years (field name: inception date).These screens would eliminate funds that werenot around during the crisis or that may nothave sufficient infrastructure (research oroperational resources) to support large inflows.Sifting Through the DataAfter the search is populated, it’s best to movethe funds to an investment list for analysis byC ON T I N UE D ON N E X T PAGE

8Morningstar Product Spotlight: Morningstar Office continuedselecting the entire group and going toMorningstar Alternative Investments ObserverFirst Quarter 2012Exhibit 2: Alternative Mutual Fund Investment ListAction – Save As – Investment List. Oncemoved to an investment list, we can addbenchmarks and category averages to the listto analyze the funds. (See Exhibit 2.)For simplicity, we only evaluated long/shortequity funds, but the general idea ofthis walk-through can be applied to the otheralternative categories.Relevant data points to consider addingwould be:1 Annual returns by year2 One-, three-, and five-year returns3 Alpha4 Beta5 Standard deviation6 Sharpe ratio7 Upside/downside capture8 Morningstar Rating for three yearsand five years9 Equity Style Box (long and short)Because alternative funds come in all shapesand sizes, it’s important to gain a generalsense for a fund’s risk attributes. Even in thelong/short equity category, funds can varygreatly over these characteristics. For example,Pyxis Long/Short Equity HEOAX hasexhibited a 30% net equity exposure onaverage over the past three years (as measuredby the fund’s monthly beta to the S&P 500through March 31), but Wasatch Long/Short’sFMLSX stock market exposure was morethan double, meaning that it took on more riskto generate its returns. On a risk-adjustedbasis, Pyxis has outperformed, as demonstratedby its positive alpha over the period. (The fundsdiffer slightly in what they invest in, however.Wasatch is focused on large-capitalizationstocks, and Pyxis is more mid-capitalizationfocused, so the S&P 500 benchmark is moreappropriate for Wasatch.)Exhibit 3: Alternative Mutual Fund Correlation Matrixthe fact that management covered its shortsearly and does not hedge using ETFs orfutures. Over the past three years, however,Wasatch Long/Short has performed worse thanDiamond Hill Long/Short DIAMX in downmarkets, as demonstrated by its 70% downsidecapture ratio. Marketfield MFLDX, on theother hand, has the best upside capture ratio,which explains its current 5-star rating.It’s important to isolate funds that can capturemarket gains in addition to limiting losses.Correlation Matrixes and Risk/Reward ChartsAnother interesting data point to analyze ishow the funds perform in different marketenvironments. Diamond Hill, for example, fellmuch further than its peers in 2008 because ofMorningstar Office is also a great tool forcomparing correlations among funds and assetclasses. Going back to the list of long/shortequity funds, we created a correlation matrix byplacing a check mark next to each of the fundsand clicking Action – Charts – CorrelationMatrix (to add the S&P 500, we clicked EditInvestments once inside the chart). In Exhibit 3,we can see that Pyxis Long/Short Equity hasexhibited the lowest correlation to the S&P 500over the past three years, which alongwith its positive Sharpe ratio means that thisfund should improve a traditional portfolio’srisk-adjusted returns. To compare Sharpe ratiosor risk/reward across funds, we createda Risk/Reward chart by going to Action – Charts – Risk/Reward. Marketfield has ahigher risk/reward profile (see Exhibit 4) but ahigher correlation to equities.C ON T I N UE D ON N E X T PAGE

9Morningstar Product Spotlight: Morningstar Office continuedBuilding Model PortfoliosMorningstar Alternative Investments ObserverFirst Quarter 2012Exhibit 4: Alternative Mutual Fund Risk/Reward ChartSubscribers of Morningstar Office can alsobuild model portfolios. Adding alternativeinvestments to model portfolios allows users toglean insight into how these funds wouldhave added, or detracted, from client portfolios.We started by creating a basic 60/40portfolio in the investment planning section,entering the Barclays Aggregate Bond Index(40%) and S&P 500 (60%) in the holdings.The model we created was a variable model,meaning we could adjust the rebalancefrequency and even change the model’sholdings over time.Next, we reduced the equity allocationto 55% and added 5% to Pyxis Long/Short.Indeed, on a five-year basis (the fund’sinception was in 2006), our portfolio’s Sharperatio improved to 0.36 from 0.34. (See Exhibits5 and 6.) The absolute performance of theportfolio also improved over the past five years.To visually demonstrate how the abovemodel performed over time, an advisor couldrun a snapshot report by going to Reports – Analytical Reports – Snapshot, or hecould generate a monthly rolling-return chart byselecting the securities and going to Action – Charts – Rolling Return (bar). Data fromthe rolling-return chart can then be exportedinto Excel to demonstrate how themodel performed over certain time periods.Exhibit 5: Standard 60/40 Model PortfolioConclusionMorningstar Office can help advisors segregatethe ugly from the investable when it comesto alternative investments. Because alternativeinvestments demand a higher degree ofsophistication, clients will appreciate it ifadvisors go the extra mile in their research.Morningstar Office is a useful tool to weed outthe noise and to display the data in amanner that’s both visually pleasing and easyto comprehend. KExhibit 6: Alternative Mutual Fund Model Portfolio (5% allocation to HEOAX)

10Morningstar Alternative Investments ObserverFirst Quarter 2012Industry Trends:Alternative Mutual FundsThe managed-futures rush continues.byTerry TianAlternative Investments AnalystAlternative Mutual FundsThe velocity of managed-futures mutual fundlaunches is only getting faster, despite thecategory’s dismal performance over the past fewyears. A mere five years ago, only onemanaged-futures mutual fund existed—Guggenheim (formerly Rydex) Managed FuturesStrategy RYMTX. Since this niche investmentstrategy delivered chart-topping performance in2008, investors have been piling into managedfutures. Now there are more than 30 fundsin the category, 13 of which launched just lastyear. In the first three months of 2012, sixnew managed-futures mutual funds came to themarket, including Goldman Sachs ManagedFutures Strategy GMSAX, Direxion IndexedManaged Futures Strategy DXMAX, ForwardManaged Futures Strategy FUTCX, and threefunds from Equinox—Equinox Eclipse StrategyEECIX, Equinox John Locke Strategy EJLIX,and Equinox QCM Strategy EQQCX. (All threeare subadvised by single commodity tradingadvisors, or CTAs.) On the exchange-traded fundside, ProShares filed for three managed-futuresETFs last November, which would bring thetotal number of managed-futuresexchange-traded products to five. Assetwise,although the managed-futures category isstill one of the smallest categories—roughly 7.8 billion in assets as of Feb. 29—the growthrate is astonishing. The category almost doubledin assets last year (because of inflows of 3.6 billion), and it gathered another 378million in the first two months of 2012.The newly launched managed-futures offeringsare unique for a couple of reasons. First,prior to this year, there were no single-managerCTAs. Equinox has paved the way for privatehedge funds or CTAs to come to market in a1940-Act vehicle while still charginghedge-fund-like fees (2% management and30% performance fees in the case of theabovementioned Equinox funds). Second, theseofferings, whether they are actively managed orthird-party index-tracking, all follow strategiesthat diverge from the crowd. Whereas theoriginal managed-futures funds were based onthe S&P Diversified Trends Indicator, the newfunds attempt to capture momentum in differentways. For example, Equinox Eclipse Strategyutilizes macroeconomic and fundamental inputsin the price-based momentum model. EquinoxJohn Locke Strategy incorporates volatilityexpansion (profits from increased marketvolatility) and mean-reversion strategies into thetrend-following algorithm. And Goldman SachsManaged Futures Strategy incorporatesshort-term, intermediate-term, and long-termprice trends.F

commodities strategy, while a small percentage even invested directly in commodities such as farmland or timberland. Those institutions that do not believe commodities to be alternative investments primarily responded that they do invest in commodities but consider it a core allocation. Advisors' responses indicated a slightly lower