Key Takeaways
- • Morningstar's director of global ETF research Ben Johnson found that 13 of 14 liquid alternative ETFs with at least three years of performance history failed to meet two tests: low or negative correlation with stocks and bonds, and positive returns above bond returns.
- • Johnson's test used an ETF tracking the Barclays Agg as the bond proxy, and some of the failing funds posted negative returns or were strongly correlated with equities or bonds.
- • Johnson cautioned that three years is a short window and that it coincided with one of the longest bull markets in history, so the jury is still out, though early signs are not encouraging.
- • Morningstar's Silver-rated picks were the AQR Style Premia Alternative Fund and the Vanguard Market Neutral Fund, both long-short strategies exploiting value and momentum factors that passed both tests over trailing three- and five-year periods.
- • Johnson said alternatives are not a must-have for portfolios, and he argued that index approaches are inherently disadvantaged in this space compared with best-of-breed active specialists.
Summary
Morningstar's Ben Johnson, director of global ETF research, presented research on whether liquid alternative ETFs have delivered on their promise of diversification. Liquid alternatives are mutual funds and ETFs that offer strategies traditionally found in hedge funds, such as long-short equity, in a format investors can trade daily. Johnson said the liquidity feature gained demand after the financial crisis, when many hedge fund lock-ups left investors unable to exit. The tradeoff, he noted, is that liquidity requires portfolio holdings to be liquid, which excludes much of the opportunity set available to hedge funds.
Johnson screened the universe of exchange-traded products in Morningstar's alternatives categories, narrowing it by track record. He identified 14 ETFs, plus a few exchange-traded notes, with at least three years of history, some with five. He tested whether each fund would diversify equity risk, diversify fixed-income risk, and deliver a positive return, without expecting beta of one to stocks or bonds. Thirteen of the 14 funds failed on one or both measures: they were highly correlated with stocks or bonds, or returned less than the Barclays Agg proxy, or posted negative returns. Johnson described some failures as occurring "in spectacular fashion."
Johnson cautioned against a firm verdict. Three years is short, and the period coincided with one of the longest bull markets in financial history, so the strategies have not faced a drawdown comparable to the financial crisis or the tech bubble collapse. He said the jury is still out but early signs are not encouraging.
Johnson argued that active management can add substantial value in alternatives, and that indexed approaches are often "ham-fisted," since back-tests can be built to look successful but forward performance is harder to deliver. Morningstar's two favorites were the AQR Style Premia Alternative Fund and the Vanguard Market Neutral Fund, both rated Silver. Both use long-short strategies targeting value and momentum factors, and both passed the correlation and return tests over trailing three- and five-year periods. Johnson said alternatives are not a requirement for a portfolio, since stocks and bonds have historically diversified each other, and advised investors to shop carefully for best-of-breed funds with long track records.
Johnson screened the universe of exchange-traded products in Morningstar's alternatives categories, narrowing it by track record. He identified 14 ETFs, plus a few exchange-traded notes, with at least three years of history, some with five. He tested whether each fund would diversify equity risk, diversify fixed-income risk, and deliver a positive return, without expecting beta of one to stocks or bonds. Thirteen of the 14 funds failed on one or both measures: they were highly correlated with stocks or bonds, or returned less than the Barclays Agg proxy, or posted negative returns. Johnson described some failures as occurring "in spectacular fashion."
Johnson cautioned against a firm verdict. Three years is short, and the period coincided with one of the longest bull markets in financial history, so the strategies have not faced a drawdown comparable to the financial crisis or the tech bubble collapse. He said the jury is still out but early signs are not encouraging.
Johnson argued that active management can add substantial value in alternatives, and that indexed approaches are often "ham-fisted," since back-tests can be built to look successful but forward performance is harder to deliver. Morningstar's two favorites were the AQR Style Premia Alternative Fund and the Vanguard Market Neutral Fund, both rated Silver. Both use long-short strategies targeting value and momentum factors, and both passed the correlation and return tests over trailing three- and five-year periods. Johnson said alternatives are not a requirement for a portfolio, since stocks and bonds have historically diversified each other, and advised investors to shop carefully for best-of-breed funds with long track records.
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