In earlier articles we have discussed alternative mutual funds as being primarily diversifiers of risk. There are, however, alternatives that are or should be viewed as return enhancers.
In Alternatives: The Underused and Underappreciated Diversification Tool (Lipper Insight: http://lipperalpha.financial.thomsonreuters.com/author/andrew-clark/page/2/) we noted that multi-strategy funds, currency funds, quant funds, and managed futures funds appear to be better used as return enhancers and not as diversifiers. We will now look at U.S. currency alternative funds in more detail to see if they are indeed return enhancing.
There are 84 distinct currency alternative funds in the U.S.; 31 of them have four years or more of performance history, and 77 have six months or more of history. We look at the list of 77 first, since currency market volatility, as measured by various instruments and indices, has been quite high over the past few months. This level of volatility may help us determine (not definitively) if currency alternative funds work as diversifiers.
From the aspect of typical measures of downside risk–worst drawdown, semi-variance, and downside deviation–only a few, about 10% – 15%, of the currency funds have performance that warrants them being considered diversifiers versus return enhancers. From a risk-adjusted return standpoint the pool gets somewhat turned on its head; those funds with some of the highest downside risk values are the ones with the positive Sharpe and Sortino ratios. Many of the funds with very good downside risk values have Sharpe or Sortino ratios that are either negative or that hover just either side of zero. This last statement is a sign that good downside performance is not linked to good risk-adjusted performance. This linkage could very well be a clue that adding currency funds to a portfolio will not diversify the portfolio’s risk. For this to occur the Sharpe ratio of the alternative investment needs to be higher than that of the portfolio.
Looking at the 31 funds having performance data going back four years or more, the same phenomena are observed. The funds with the best Sharpe ratios are more often the funds with the higher risk. And in the four-year period most of the good Sharpe-ratio funds have Sharpe values that make them questionable additions to an existing portfolio. Also, those funds with the good Sharpe ratios are more often those funds with the best annualized returns.
In this brief examination of currency funds we find that good risk-adjusted performance is tied to good non-risk-adjusted return, not to good values of downside risk. We draw the initial conclusion, then, that currency funds typically are not diversifiers of risk but are a way of enhancing a portfolio’s return.