Morningstar Gets Alternatives Wrong

How to use alternatives and have proper expectations for what they can and cannot do.

Morningstar had some interesting comments about liquid alternatives. Liquid alts as they are sometimes called have been around for a while but the term liquid alts has not been commonly used for very long. I first started writing about them more then ten years ago, calling them diversifiers. My general take has always been that used in moderation and tactically, certain liquid alt strategies can help smooth out the ride as part of a defensive strategy when the equity market warns of trouble.

One of Morningstar's criticisms is that;

...alternatives must generate real-world success stories that advisors and investors can point to in order to justify their faith in the category. To date, these have been few and far between. Investors ignored alternative strategies before the financial crisis of 2007–08, but then flocked to them in its aftermath, buying what they wish they had bought two years earlier.

Maybe they needed to look a little harder. I wrote about them before the crisis, during the crisis and after the crisis. Before the crisis I essentially said these could help. The the crisis unfolded I shared how I was using them and which ones I was using. As the bear market was winding down I said these should not be permanent holds, at least not in any size because they won't do anywhere near as well as equities most of the time. Obviously my blog has a low probability of catching anyone's attention at Morningstar but as I was writing about these and how to use them, so were others, the information was there for those who chose to look. You can visit the archive at RandomRoger.com to look at what I was saying back then and all the way along.

Morningstar says that success stories need to be shared by advisors to help promote alternatives' effective use. This is problematic where compliance is concerned. If I say oh, last year I bought the ABC Alternatives Fund and it did such and such, that is cherry picking and is a no can do. If and when the market rolls over I will disclose what I do in client accounts as I do it as I have always done. I have owned a couple of alternatives for clients for many years, just small amounts in a gold ETF, a traditional mutual fund that targets merger arbitrage and a hedge fund replication ETF.

Morningstar also says that costs of alternatives need to come down. I have no pushback against hoping costs come down but if an inverse fund does what it is supposed to the next time there is a bear market, it is worth the expense to me. If you disagree, then obviously you would not use an inverse fund. More broadly, if you find any alternative to be too expensive then just don't use them.

If you do some research on alternatives you will find plenty of content telling you that their performance is bad. It is important to understand that equities are the best performing asset class over the long haul. Alternatives that have less volatility and a low correlation to equities should be expected to underperform over the long haul. They can outperform in the short term like in the 18-30 month average bear market duration. If you successfully choose a couple of alternatives that do perform well in a bear market for equities then you will have effectively muted some amount of the bear market's full impact. The three alternatives I mentioned owning above, have badly lagged the equity market in the bull market because they are not equity proxies. They are all down just a fraction of what the S&P 500 has done in the last five days. Five days isn't significant but is a microcosm for how this works.

Again, this is the same message I have been putting out for more than a dozen years and will continue to share here at TheMaven.