How Alternative Asset Managers Work

36 Pages·2014·1.63 MB·English

Volume 6, Number 2 Fall/Winter 2014
2 8 26 Quarterly Data Review: Q2 2014
Let Correlations Be Your Guide
How Alternative Asset
A useful tool to help fine-tune your
Managers Work alternatives allocations. 33 Hedge Fund Database Overview
Alternative asset managers
13
are capitalizing on investor Let’s Make a Deal
Rising deal activity boosts merger-arbitrage
interest in alternative
funds.
investments.
16
Medalist Spotlight:
Merger Fund
Fund Reports
18 AllianceBernstein Select US Long/Short
20 AQR Style Premia
22 Balter Long/Short Equity
24 Franklin K2 Alternative Strategies
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2 Morningstar Alternative Investments Observer
Fall/Winter 2014
How Alternative Asset Managers Work
Alternative asset managers are capitalizing on
investor interest in alternative investments.
primarily by managing money for private and Editor’s Note:
public pension funds, endowments, foundations, In the cover story of this issue of AIO, Stephen
and other institutions, as well as for high-net- Ellis, director of financial services research
worth individuals. Most of the industry’s largest in Morningstar’s equity research department,
players—including Blackstone BX, Apollo discusses the trends driving growth and
by
Stephen Ellis APO, and Carlyle CG—started off in private profitability in the major publicly traded alter-
Director, Financial Services equity but have expanded their reach over time native asset managers. This analysis is
Equity Research
to include credit, real estate, secondary funds, fascinating not only for the insight it offers into
and funds of funds. Other players—like Oaktree these firms’ viability as investment oppor-
OAK and Ares ARES—have focused almost tunities, but the perspective it provides on the
exclusively on credit opportunities (distressed, mechanics of the alternative investment
We believe that the alternative asset manage-
high-yield, convertibles, and mezzanine) with industry as a whole.
ment industry is structurally attractive
great success. The industry has tended to follow
and generally misunderstood by investors. The
the same business model for going public, Ellis focuses on private equity as the primary
relative newness of the industry to the public
structuring as partnerships (which file K-1s), engine driving the industry, while liquid
markets, not to mention the complexity of
with the investment managers themselves listed alternatives barely register. Still, many of these
its accounting, has kept many from looking at
as the general partners, and investors in their firms have been dipping their toes into the
the group more closely. We also believe that
funds designated as limited partners. Investor liquid space—most notably Blackstone, with its
investors do not fully appreciate the business
interest in the products being offered by the multistrategy mutual fund, but also Carlyle and
quality or growth prospects for the biggest
alternative asset managers has increased since KKR, with varying degrees of success. Others
and best alternative asset managers, which
the 2008–09 financial crisis, with pension have been actively investigating the space
have, in many cases, greatly expanded beyond
funds—many of which have turned to riskier and as well. The private equity business will likely
their initial roots in private equity. In this
higher-returning assets during the past 10 to 15 remain hugely profitable, but private hedge
report, we seek to answer some of the biggest
years in an attempt to close funding gaps—lead- funds have seen asset growth slow, so it’s not
questions that industry participants and
ing the way. In particular, we think that private surprising that these firms would seek
investors might have about the group, including
equity performance has helped increase the level ways to diversify their revenue streams over
how alternative asset managers generate
of interest in alternative assets. Returns for the time. Whether any of these firms over the long
revenues and how best to evaluate the industry’s
top quartile of private equity funds at 26% and term can successfully translate a “2 and
competitive advantages.
29% during the past 10 and 20 years, respec- 20” carried interest mentality to the far more
tively, versus single-digit returns for the MSCI price-competitive world of retail mutual
What Is the Alternative Asset Management
World Index during the same time frame funds—and which models of engagement are
Industry?
have contributed to a substantial increase in the most promising—remains to be seen.
The publicly traded alternative asset managers
assets under management for the industry
are global institutions with decades of experi-
overall during the past 20 years. Given the level expect continued healthy levels of growth in
ence investing in nontraditional asset classes,
of interest that still exists for alternatives, we AUM for the industry overall going forward.
How Alternative Asset Managers Work 3 Morningstar Alternative Investments Observer
Fall/Winter 2014
Exhibit 1 Alternative Assets Under Management Over Time (in $Trillions) their decision to invest in the fund. Once a
limited partner has committed capital to a fund,
Private Equity Hedge Fund it is required to contribute this capital on
demand. The manager of the fund will then
5.0
invest the capital over three to five years. The
4.5
latter stages of a fund’s life are when the
4.0 manager sells off the company to a strategic
acquirer or another private equity firm, or takes
3.5
it public and earns incentive fees. Limited
3.0
partners typically recycle their realized gains into
2.5 the latest fund being offered by the manager,
provided that the performance of the previous fund
2.0
was satisfactory, making the timing and the size
1.5
of any distributions to limited partners a critical
1.0 consideration for the alternative asset manager.
0.5
Value creation within private equity typically
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 comes from three sources: leverage, multiple
expansion, and operational improvements. In
the 1980s, the amount of equity that a private
Source: Preqin, McKinsey, Hedge Fund Research, Morningstar.
equity firm’s general partners put into a trans-
Exhibit 2 Insider Ownership and Level of Voting Control by Asset Manager action was typically less than 10% of the deal’s
value, with the rest of the acquisition price
being funded by debt. The leverage, combined
Insider Ownership Voting Control
with modest operational changes, typically
120
% generated substantial returns. In the 1990s, as
banks and limited partners grew more reluctant
100
to fund highly leveraged deals after a series
of failures, the equity contributions of the general
80 partners increased to the 20%–40% range,
reducing the amount of leverage-fueled gains
60 that could be produced. In terms of multiple
expansions, the private equity industry has typ-
40 ically seen the best returns when it has been
able to put capital to work in a difficult environ-
20 ment (such as following the 2008–09 financial
crisis). Blackstone, in particular, had great
success buying highly cyclical companies during
Blackstone Fortress KKR Apollo Ares Och-Ziff Oaktree Carlyle
the trough, using leverage to multiply the gains
on their investments as the industries and
general economy recovered. By the late 2000s,
Source: Company reports, Morningstar.
the private equity industry had generally turned
The most recognizable fund structure used by the when potential limited partners (typically to operational improvements to drive intrinsic
alternative asset managers is a closed-end fund restricted to professional and wealthy investors) value creation at its investments. Carlyle,
model, which would describe the traditional can subscribe to the fund. The fund can be Blackstone, Apollo, and KKR & Co. KKR, among
private equity fund model, which typically lasts considered a blind pool, as limited partners do not others, have built out substantial employee
10 to 11 years. In most cases, a general partner have any idea of the potential investments the bases of in-house executives, consultants, and
will identify a promising investment niche and fund could make, relying solely on the man-
engage in a 12- to 24-month fundraising period ager’s track record and reputation when making
How Alternative Asset Managers Work 4 Morningstar Alternative Investments Observer
Fall/Winter 2014
Exhibit 3 Alternative Asset Manager Moat Framework Heat Map
Company Moat Trend Fund Lives Operations Fundraising Human Capital Product Portfolio Reputation Culture Geographic Reach
Blackstone Wide Stable
Carlyle Narrow Stable
Apollo Narrow Stable
KKR Narrow Stable
Oaktree Narrow Stable
Ares Narrow Stable
Och-Ziff None Stable
Fortress None Stable
Strong Neutral Weak
Source: Morningstar.
advisors who have decades of industry majority of voting rights through different unit We think there are a few other factors that align
experience and can successfully revitalize a classes. The industry typically pays out the unitholder, limited partner, and general partner
company through cost-cutting, acquisitions, or vast majority (80% to 90%) of its distributable interests. Many general partners take very
other strategic maneuvers, increasing the (cash) earnings as distributions to unitholders. limited or no compensation (Howard Marks of
chance of producing a successful investment. Oaktree takes no pay) other than the distributions
Despite the lack of control over the firms (and they receive, thanks to their unit ownership.
What About Unitholders’ Interests? the loss of other related rights that typically Their ownership aligns their interests with unit-
In 2007, the industry became publicly traded accrue to unitholders), we still think unitholders holders in terms of growing distributions
for the first time with the initial public offerings are given a fair deal by the partnerships. over time. In 2008–09, the industry’s leaders
of Och-Ziff OZM, Fortress FIG, and Blackstone. Unitholders have placed tremendous pressure saw a substantial decline in the overall value of
KKR listed on the NYSE in 2010, Apollo began to on the partnerships to diversify their revenue their units as well as sharply lower distributions
trade on the NYSE in 2011, and Oaktree and streams away from the volatile and more alongside common unitholders. In addition,
Carlyle followed in 2012. Ares only recently market-dependent private equity business, as though the general partners in most firms typically
became public, in early 2014. The main reasons they’ve emphasized the value they place contribute 1% to 2% of a manager’s capital to a
for the pursuit of IPOs were increased liquidity on a steady stream of management fees earned fund, insiders have been known to contribute as
for the partners’ large stakes in the firms and from a diverse asset manager. In response, much as 2% to 3% (leading to situations like
the ability to pursue acquisitions. Now, unithold- the industry has engaged in a fairly aggressive Apollo’s $18.4 billion Fund VIII, to which insiders
ers entered the equation. Unitholders neither acquisition spree to expand the scope of the and the general partner committed roughly $900
have a direct ownership stake in any of the offerings to well beyond their traditional roots in million). This leaves a substantial part of
funds in which the general partners invest, nor private equity and credit to include real estate, insiders’ compensation tied to fund-level returns,
do they directly benefit from the returns that funds of funds, and secondaries, among being locked up alongside the limited partners.
they generate. However, unitholders do retain other offerings. In general, we think this is a Finally, senior managing directors and other key
partial ownership of the income generated positive move as it increases the stickiness of a individuals are typically locked up under non-
by management and incentive fees through their partnership AUM (which we view as moat- compete arrangements, which prohibit working
ownership of the general partner. Unitholders enhancing), especially when a limited partner for a competitor or soliciting clients for a year at
are essentially receiving a piece of the takes part in multiple strategies. This allows minimum. Overall, we believe interests are
management fees and carried interest that is ROICs to be earned through an increasingly generally aligned among unitholders, general
taken in by these firms, after operating diverse business mix rather than on the strength partners, and limited partners.
expenses (and the capital that management of a given firm’s particular franchise, insulating
expects to reinvest back into the business) are it from the potential for strategies to become How Do Alternative Asset Managers
deducted. However, insiders typically retain commodified, as many hedge fund strategies Make Money?
the majority of units held, as well as the have, in our view. The publicly traded alternative asset managers
generate revenue in three different ways:
How Alternative Asset Managers Work 5 Morningstar Alternative Investments Observer
Fall/Winter 2014
Exhibit 4 Alternative Asset Managers’ AUM Breakout by Strategy (in $ Millions) stepping to a lower level as the fund enters the
realization portion of its useful life when
Private Equity Solutions (FoF) Credit Real Estate Hedge Funds incentive income can be generated. Management
fees are charged for the full life of the fund,
300,000
which is usually 10 to 11 years. Lower fees are
sometimes charged for strategies where the
250,000
expected return is lower.
200,000
Incentive fees or carried interest. Hedge fund
structures typically earn 20% of the fund’s
150,000
capital appreciation per year, subject to a high-
water mark in the 5%–8% range. Carried
100,000
interest applies to carry funds (such as private
equity), where the range of incentive fees can
50,000 vary depending on the strategy, but are typically
between 10% and 30% of any realized profits
on an investment, subject to a high-water mark
Blackstone Carlyle Apollo KKR Oaktree Ares Och-Ziff Fortress
in the 7%–10% range. If a fund does not
achieve its preferred return over the life of the
fund, managers are obligated to repay the
Source: Morningstar.
amount in excess of the agreed-on split
Exhibit 5 Alternative Asset Managers’ AUM Breakout by Composition in Percent to the limited partners. This is known as a
clawback obligation.
Private Equity Solutions (FoF) Credit Real Estate Hedge Funds
Investment income. To align their interests with
100
% the limited partners, the general partners
typically contribute company capital, as well as
80 their own capital, to a fund. The range varies
depending on the size of the fund and manager,
but is usually about 1% to 5% of a fund’s AUM.
60
These investments are typically held on the
company’s balance sheet.
40
Transaction, monitoring, and other advisory fees
can also be charged on portfolio holdings,
20 but thanks to limited-partner pressure during the
past few years, 50% to 100% of these fees
(at least for the major players) are generally
Blackstone Carlyle Apollo KKR Oaktree Ares Och-Ziff Fortress
rebated to limited partners through a reduction
in their management fees.
Source: Morningstar.
How Do We Determine Alternative Asset
management fees, incentive fees, and invest- value. Fees can vary greatly depending on
Manager Moats?
ment income, which are then shared with the size of the fund, the current fundraising envi- Traditional asset managers such as BlackRock
employees and unitholders. ronment, the targeted investment opportunity, BLK have earned Morningstar Economic
or the level of capital commitment made by the Moat Ratings, thanks to high levels of switching
Management fees. These range between 0.3% limited partner, among other items. Typically, costs and strong intangible assets. Once AUM
and 2.0% and are commonly charged on we’d expect to see higher fees charged during flows into the traditional managers, it tends to
committed capital, invested capital, or net asset the investment period for a fund, with rates
How Alternative Asset Managers Work 6 Morningstar Alternative Investments Observer
Fall/Winter 2014
stay there, as annual redemption rates of 2. Operational expertise. Large general partners thus investment opportunities) across a wider
around 30% demonstrate. The traditional asset such as KKR and Blackstone have increasingly range of strategies and asset classes are more
managers can build on that switching-cost provided operational and strategic expertise to likely to inbound incremental capital.
advantage by offering a diverse product mix, their portfolio companies to create value. For
having greater geographic reach, being strong in example, we estimate that Blackstone employs 6. Reputation. Managers that have a long and
multiple distribution channels, and having a more than 70 professionals (including ex-CEOs), successful track record of strong investment
reputation as a world-class investment and KKR has nearly 100 advisors and consultants performance (preferably over decades), and also
manager. A niche focus on retirement accounts who advise portfolio companies on strategic have a history of treating limited partners with
and tax-managed strategies creates even higher and operational insights. Duplicating these units respect, are better positioned, in our view, to
switching-cost advantages for the traditional would not only be expensive from a com- attract incremental capital than a startup with a
asset managers. We also believe that a singular pensation perspective, but also would require a much more limited track record.
corporate culture dedicated to a common sizable and active private equity operation.
purpose, as well as a deep and wide product set 7. Culture. We think alternative asset managers
across multiple asset classes, allows asset 3. Fundraising expertise. While we believe that that operate across a broad set of investment
managers to hold on to assets even longer— the top executives at alternative asset strategies and product offerings, and that
making these some of the key differentiators managers play a critical role in raising new incentivize these different teams to work together
between wide and narrow moats in the industry. funds because of strong and established (either by compensation or through a common
relationships with limited partners, the largest culture of sharing ideas), have an additional
Alternative asset managers, in our view, have alternative asset managers have substantial competitive edge. We believe Carlyle, Black-
attributes that can make these moat sources— fundraising organizations at their disposal. stone, and KKR have some of the strongest
switching costs and intangible assets—even Carlyle, for example, has about 80 professionals internal cultures and are actively working
more indelible. We’d also note that from a that segment the markets by region, by product together to put more money behind their best
financial perspective, putting 1% to 2% of their line, and by distribution platform. ideas through idea sharing. For example,
capital at risk within a fund in exchange for Blackstone put more than $10 billion to work
20% of the profits and an ongoing management 4. Human capital. Firms with a larger number of across the firm supporting its improving
fee in the 1%–2% range is an extraordinarily investment professionals operating across housing thesis, which was based on insights
lucrative deal for the alternative asset managers. a broader range of asset classes will generally gleaned from its private equity, credit, real
Our moat framework for the alternative asset have more-extensive and deeper relationships estate, and solutions segments, and resulted in
managers focuses on several key factors: with buyers and sellers, which will generate investments in single-family homes, home
higher-quality investment opportunities. We automation services, credit financing, nonper-
1. Fund lives. Unlike the products of most tradi- also believe a higher number of investment pro- forming residential loans, mortgage servicing
tional asset managers, which have to rely fessionals can drive a substantial increase in rights, and the purchase of homebuilder and
on investor inaction to keep annual redemption the number of limited-partner relationships that related equities.
rates low, the products offered by the alterna- an alternative asset manager develops over
tive asset managers can have lockup periods, time, lowering the implicit cost of acquiring 8. Geographic reach. The larger an alternative
which prevent investors from redeeming part or incremental AUM. We think of this element asset manager’s base of global offices,
all of their investment. Generally, we favor as the “deal funnel,” as it focuses on the size investments, and overseas clients is, the further
longer lockup periods for limited-partner capital and scope of the human capital an asset along it will be in developing relationships
because of the substantial switching costs. manager retains. In short, the greater number with the limited partners of tomorrow (which
A long lockup period, such as the 10- to 11-year of investment professionals in-house, the are increasingly sovereign wealth funds), as
time frame for private equity funds, implies more opportunities the manager will have to well as sourcing international deal flow. Carlyle
a great level of trust between the limited and land lucrative deals. is by far the leader here, with about 25%
general partner, as the limited partner cannot of its investments being made outside of North
redeem its capital for years. In contrast, hedge 5. Product portfolio. Limited partners are America and Europe during the past few years,
fund redemptions can occur as frequently increasingly looking to consolidate their assets versus 15% at its major peers. Carlyle also
as quarterly. with fewer managers that operate across a has the largest amount of region-specific funds,
wider range of asset classes and strategies in and investors are increasingly looking for
an attempt to reduce oversight costs. Managers emerging-markets funds.
that can develop and source deal flow (and
How Alternative Asset Managers Work 7 Morningstar Alternative Investments Observer
Fall/Winter 2014
How Do We Determine Moats for between private equity and credit, and Ares and weighted toward private equity. We think both
Each Manager? Apollo are focused nearly entirely on credit partnerships can do more here to leverage their
Though all of the publicly traded alternative asset AUM. Finally, Och-Ziff and Fortress are primarily existing relationships with limited partners to
managers broadly operate under the same weighted toward hedge funds and credit, with bring in more AUM, and as both asset managers
business model of collecting and retaining fee- Fortress retaining a sizable but declining private have been highly aggressive in acquiring new
earning AUM and making successful invest- equity franchise. strategies and AUM, we think they will be able
ments, we think investors should understand to leverage the newly expanded product
several key elements that differentiate each of From a fundraising perspective, there are also portfolios and relationships to boost fundraising
these managers. We tend to award the industry differences in the quality of alternative asset efforts going forward.
narrow moats because of the explicit switching managers. Scale is increasingly becoming more
costs associated with carry funds’ long important in fundraising. We believe dedicated There are also substantial variations between
lives, which are 10 to 11 years. We also award teams and global offices are needed, because asset managers in terms of the strength of their
narrow moats based on the strong reputations the number of marketing channels is fragment- product offerings and geographic reach, and the
and the scale needed to invest in the back-office ing across the industry. Inflows from pension depth of their human capital. Blackstone and
systems required to meet increasingly tougher funds and funds of funds are increasingly stag- Carlyle own some of the deepest product
regulatory and limited-partner transparency and nating, while sovereign wealth funds and retail portfolios, which allow limited partners to invest
reporting requirements. investor channels are growing in importance in multiple funds and strategies, at a variety of
and demanding higher levels of marketing price points, with varying levels of transparency,
It also helps to look at the level of total AUM investment than in the recent past. At more than size, and time commitments. We also think the
each of the alternative asset managers is $150 billion from 2011 to 2013, Blackstone pair benefits from a substantially greater
managing, as well as the diversification that has raised more investor capital than its next number of investment professionals and wider
exists in their asset bases. Of the eight publicly four largest peers combined. The firm has global reach (as measured by number of offices
traded alternative asset managers, Blackstone accomplished this remarkable feat primarily worldwide), where the relationships in place
at $271 billion has the largest level of AUM through introducing new and innovative ensure access to the highest-quality investment
dedicated to alternative assets and owns the strategies that meet limited-partner needs. For opportunities and ensure that they are first in
only sizable real estate division, with Carlyle at example, Blackstone Tactical Opportunities, mind for any limited partner looking to increase
$199 billion being a close second. Apollo stands which seeks to invest in areas that might not fit its alternatives allocations. KKR also stands out
out next with $158 billion in mostly credit AUM, within the firm’s traditional private equity, from its peers, as it is rapidly expanding its
while KKR, Oaktree, and Ares follow up with credit, or real estate niches, quickly raised $5.6 product portfolio and adding investment talent,
$102 billion, $86 billion, and $77 billion in AUM, billion, and the partnership is pursuing and we think it will be able to convince more
respectively. Och-Ziff and Fortress are the fundraising for a second fund this year. clients to sign up for multiple strategies going
two smallest players in the group at $42.6 bil- forward. Apollo, Ares, and Oaktree have largely
lion and $36 billion (excluding its traditional Carlyle has also been very successful, pulling in remained within their traditional niches within
fixed-income AUM), respectively. more than $50 billion during the past few years, private equity and credit, and they have
thanks to its broad and deep fund portfolio, pursued only modest step-out strategies in
Blackstone is also the most diverse of the which includes many region-specific funds, letting recent years. Finally, Och-Ziff and Fortress have
alternative asset managers. It garners 30% investors target specific strategies and very limited product portfolios, geographic
of its AUM from real estate, 24% from geographies that meet their allocation require- reach, and a small cadre of investment pro-
private equity, 24% from credit, and 21% from ments. Meanwhile, Oaktree and Ares have done fessionals, which we believe limit their ability
solutions, where the firm directly allocates well raising money for their credit funds, to raise funds, develop new strategies, and
investor capital to hedge funds but offers and at $33 billion and $27.5 billion ($34 billion inbound attractive investments. K
options to others. Only Carlyle comes close to including real estate and private equity for
the same level of diversification as Blackstone, Ares), respectively, their inflows compare favor-
with 50% of its AUM devoted to private ably against Blackstone’s $55 billion in credit
equity carry funds, 29% to solutions, where it inflows and are stronger than their next-closest
primarily allocates investor capital to private peer, Apollo, at $12 billion in credit fundraising.
equity funds, and 12% and 6% in credit and real KKR and Apollo delivered $36 billion and $33
estate, respectively. KKR is mostly split billion in AUM inflows, respectively, mostly
8 Morningstar Alternative Investments Observer
Fall/Winter 2014
Let Correlations Be Your Guide
A useful tool to help fine-tune your
alternatives allocations.
exhibits a near zero correlation to fixed income. alternatives correlations, since these funds
Therefore, the fund makes for an excellent combine multiple alternatives strategies.
portfolio diversifier, right? Unfortunately, there’s During the last five years through September,
a problem with this assumption: This fund’s the multialternative category has exhibited
correlation to equities is 0.77. If an investor had a correlation of 0.68 to the S&P 500, while
by
80% of his money in equities, then diversifying exhibiting a negative 0.02 correlation to the
Josh Charney
Team Lead, Alternative his fixed-income allocation into this fund would Barclays U.S. Aggregate Bond Index (we’ll
Strategies Research
probably create unintended consequences by discuss why that’s important a bit later).
potentially increasing his equitylike exposure.
Finally, note that correlations of liquid 1940 Act
Thus, the process of determining alternatives mutual funds aren’t that dissimilar to hedge
Investors have been plowing money into
allocations hinges greatly on the asset-class funds. The correlation of the Morningstar
alternative mutual funds at an astounding rate.
composition of the existing portfolio. A heavy MSCI Composite Asset Weighted Hedge Fund
Last year, alternatives inflows shattered records,
fixed-income allocation, for instance, Index is 0.78 to the S&P 500. That index
as investors poured in $95.4 billion, including
will require a drastically different alternatives includes some long-only hedge funds and skews
non-traditional-bond funds, while total assets
allocation than an equity-centric portfolio. toward equity-based strategies, inflating its
stood at $311 billion at the end of August. It’s
correlation slightly.
questionable whether all of the new investors in
alternative funds understand how to properly A Word on Alternatives Correlations
allocate to alternatives. The allocation process Correlations of alternative funds vary widely. Creating a Model
Generally, long-short equity funds have the One standard method of determining appropri-
can be counterintuitive when it comes to alter-
highest correlation to the S&P 500 (0.78 during ate asset allocation is to use an optimizer.
natives, leading to certain unintended conse-
the last five years). But correlations within The optimizer generates portfolios at various
quences. The purpose of this article is not only
the group vary widely—some funds such as points on an efficient frontier, seeking the asset
to break certain misconceptions, but also to
show which asset mixes are most appropriate Gateway GATEX and Wasatch FMLSX have mix that will provide the highest reward per
exhibited a correlation in excess of 0.90 unit of risk. The composition of each point along
when incorporating alternative strategies.
to equities over the last five years. Contrary the frontier can be viewed on an allocation
to their name, even some market-neutral funds spectrum, which measures the unit of expected
To understand how investors might be misusing
display extremely high correlations to the reward, on the x-axis, and the composition of
alternatives, let’s turn our attention to a rapidly
growing category—non-traditional-bond funds. market. Calamos Market Neutral Income CVSIX, each asset class, on the y-axis.
with the highest, stands at 0.95, but the cate-
This group of funds aims to offer investors low
gory has averaged 0.28 during the last five years. In order to create our model, we used forward-
correlations to traditional core fixed income by
looking market assumptions from J.P. Morgan’s
employing a mix of go-anywhere management
In order to simplify the analysis for the purposes 2014 Long-Term Capital Market Return Assump-
and hedging techniques. JPMorgan Strategy
of this article, we’ve decided to use the cor- tions. (This should not be taken as Morningstar
Income Opportunities JSOAX, for instance,
relations of multialternative funds as a proxy for supporting J.P. Morgan’s forecasts over other
Let Correlations Be Your Guide 9 Morningstar Alternative Investments Observer
Fall/Winter 2014
Exhibit 1 Allocation Spectrum: No Alternatives increases, the optimizer allocates away from
safer asset classes in exchange for riskier ones.
U.S. Cash U.S. Intermediate Treasury U.S. Large Cap Weights (%) Thus, the portfolio on the far right side is
a 100% stock portfolio with an expected return
100
of 8.49%.
90

80 Adding Alternatives
Before we add alternatives, we have to make
70
a few assumptions about their performance
60
and correlation to other asset classes. Since
50 many alternative strategies exhibit more
40 equitylike characteristics, we’re going to
assume their returns will be more in line with
30
stocks than bonds, extrapolating their average
20
correlations of 0.68. Consequently, we’ve
10 assumed alternatives will offer a Sharpe ratio
more similar to stocks than bonds. This fore-
2.08 3.08 4.08 5.08 6.08 7.08 8.08
Reward: Arithmetic Mean cast assumes that stocks offer a Sharpe ratio of
about 0.44, relatively close to J.P. Morgan’s
prediction that hedge funds will produce a
Source: Morningstar.
Sharpe ratio around 0.53. To simplify matters,
Exhibit 2 Allocation Spectrum: Alternatives 5.25% Return, 0.68 Correlation we assumed 1940 Act alternative mutual funds
will offer a Sharpe ratio of around 0.50, or a
return of 5.25% per year, and will exhibit similar
U.S. Cash U.S. Intermediate Treasury U.S. Large Cap Multialternative Weights (%)
historical standard deviation and correlation
100
to other asset classes.
90
80 Key Takeaways
The optimizer shows that a modest 20% allo-
70
cation to alternatives makes sense if a portfolio
60
has a large exposure to fixed income, around
50 50%. In general, our research finds that
alternatives are a much better diversifier for
40
bonds than stocks. In our forecast, we assumed
30
that stocks would exhibit a negative correlation
20 to fixed income. Given that belief, the best
10 diversifier for equities is actually fixed income.
Even though we assumed that alternatives
2.11 3.11 4.11 5.11 6.11 7.11 8.11
would have a higher Sharpe ratio than fixed
Reward: Arithmetic Mean
income (0.50 versus 0.37) the optimizer
justifiably allocates away from alternatives and
Source: Morningstar.
into fixed income for any allocation that requires
providers, but simply the fact that the assump- Let’s start with a simple portfolio of cash, stock, meaningful equity allotments. At most, the
tions were comprehensive, reasonable, and and bonds. Exhibit 1 shows the asset mix optimizer allocates around 20% to alternatives
available.) Because J.P. Morgan assumes cash of various points along the allocation spectrum. (Exhibit 2). But as one requires more return,
will return 2.0% per annum, the expected The line represents a portfolio with an that is moves further to the right on the x-axis of
Sharpe ratio for stocks is around 0.44 (for more expected return of 4.27%. Reward and risk both the allocation spectrum, the optimizer sheds
information on assumptions, see appendix). increase as you move from the left to the alternatives. In our forecast, fixed income is such
right side of the spectrum. As expected reward
Let Correlations Be Your Guide 10 Morningstar Alternative Investments Observer
Fall/Winter 2014
Exhibit 3 Allocation Spectrum: Alternatives 5.25% Return, 0.5 Correlation risk-adjusted returns among the assets. But if
we lowered our assumption of cash’s return,
U.S. Cash U.S. Intermediate Treasury U.S. Large Cap Multialternative Weights (%) for instance, the optimizer would significantly
ratchet up our allocation to alternatives.
100
90
Varying Our Assumptions
80 An optimizer can be thought of as an extremely
precise tool used in an inexact world. Although
70
it relies on various simulations, its output is only
60
as good as the assumptions. One remedy for
50 this circumstance is to vary one’s assumptions
40 by using sensitivity analysis. The practice is
more common in other areas of finance, such as
30
equity valuation, but the same basic principles
20
apply to asset allocation. The basic premise of
10 sensitivity testing involves varying one’s
assumptions in order to test a broader range of
2.11 3.11 4.11 5.11 6.11 7.11 8.11
Reward: Arithmetic Mean possible outcomes. For the purpose of this
exercise, we’ve varied the risk-adjusted returns
of alternatives and their correlations to equities,
Source: Morningstar.
holding all other assumptions constant. By not
Exhibit 4 Allocation Spectrum: Alternatives 5.25% Return, 0.8 Correlation varying other asset-class assumptions, it’s
easier to diagnose how the group will behave
one variable at a time.
U.S. Cash U.S. Intermediate Treasury U.S. Large Cap Multialternative Weights (%)
100
We first examined how our allocation spectrum
90 would change when we varied assumptions for
80 alternative correlations. Although a 0.68 corre-
lation of alternatives to stocks seems reason-
70
able, there are alternative funds that offer much
60
lower correlations. Exhibit 3 assumes that
50 we can build a portfolio of alternative funds that
exhibit a correlation of 0.50 to the S&P 500.
40
In this case, the optimizer calls for higher alloca-
30
tions to alternatives (30% at its max). What
20 hasn’t changed, however, is that the asset class
10 is still predominately incorporated when fixed-
income allocations are large. Alternatives are
2.11 3.11 4.11 5.11 6.11 7.11 8.11
almost useless for an investor who requires
Reward: Arithmetic Mean
returns in excess of 6%.
Source: Morningstar.
Finally, we looked at what would happen if
a compelling equity diversifier that the optimi- we added alternatives. Since we assumed that we raised the correlation to alternatives
zer allocates fully away from alternatives when cash would generate 2% in the long run, to 0.80. In this high-correlation case, alterna-
large positions in equities are required. the optimizer allocates mostly to cash at low tives become far less useful. As shown in
levels of expected return. Cash could certainly Exhibit 4, the optimizer still relies on a small
Another key takeaway is that cash competes be thought of as a competing asset class to portion of alternatives when fixed-income levels
with alternatives. Exhibit 1 showed a basic alternatives. At a 2% return per year, and with a are high, around 6% to alternatives, but finds
three asset-class portfolio, while in exhibit 2, standard deviation of 0.5%, cash offers the best