Alternative-Investment Mutual Funds, Part 2: Sources of Return

In this article we show the results of our risk decomposition for each of Lipper’s alternative-investment fund classifications.

Table 1. Factors Affecting Returns, Lipper Alternative-Investment Classifications

The analysis covered the weeks from 2/13/2009 to 2/21/2014 inclusive.

To give an explanation of each of the classifications and their factors, we start with Absolute Return.

Absolute Return funds follow a variety of strategies, with the intent (though not necessarily true for all funds) of preserving capital. The classification has a small list of risk factors, all of them with tilts toward stock market performance (high-yield bonds are sometimes referred to as stocks with coupons). No alternative beta (such as credit risk or optionality) appears in the list. The weighting toward stock factors may come as a surprise to some, but in a recent article Lipper’s Jeff Tjornehoj[4] found the correlation between Absolute Return funds and the S&P 500 is 0.55, while the correlation to the Barclay’s Aggregate Bond Index is a mere 0.03. So, is the risk factor tilt of Absolute Return funds that surprising?

Credit Focus funds have a long list of risk factors, several of them bond related. They also have three alternative beta exposures (CPPI, credit spread, and trend-following). These exposures make sense as Credit Focus funds often expose themselves to a combination of liquidity, credit, and term-structure risks, e.g., through  barbell strategies (long-/short-term debt of lower-credit-quality and short-/long-term government bonds), yield curve spread trades, or on-the-run versus off-the-run Treasury bond positions.

Equity Market-Neutral funds aim at zero exposure to specific equity market factors. Correspondingly, the factors in Table 1 show only an exposure to broad equity markets. However, the results indicate that Equity Market-Neutral funds carry a sensitivity to the covered call strategy and favor large-caps over small-caps. This seeming dichotomy between the stated objective and the risk factors can be potentially explained if we distinguish two distinctly different substyles of this strategy. One approach (often system-based) buys undervalued stocks and sells short overvalued stocks according to a value- and momentum-based analysis. The second, more short-term-oriented approach (also referred to as “statistical arbitrage”), trades in pairs based on a statistical analysis of relative performance deviation of similar stocks. Both styles naturally have different exposures to the factors examined here and hence maybe the reason for the “curious” mix of factors. By not separating the two strategies the reason for the return variance for Equity Market-Neutral funds being the lowest of all the alternatives may be explained.

Event-Driven constitutes an ensemble of various investment strategies around company-specific events, including restructuring, distress, and mergers. According to our factor model in Table 1 the average Event-Driven strategy fund comes with a rather simple set of exposures: the Gabelli fund (a merger and acquisition fund), small-cap stocks, high book to market stocks, optionality, and credit spread.

The Global Macro strategy bases its holdings—such as long and short positions in various equity, fixed income, currency, and futures markets—primarily on overall economic and political views of various countries. For example, if a manager believes the U.S. is headed into recession, then he or she might short-sell stocks and futures contracts on major U.S. indices or the U.S. dollar. Or, a manager who sees big opportunity for growth in Singapore might take a long position in Singapore’s assets. Given the apparent general focus of U.S.-based Global Macro funds, the various stock risk factors make sense, as does the optionality position that seems to favor writing covered puts versus covered calls.

We will not spend time on Long/Short Equity funds, since the risk factors in this study yield the same results as those of a recent paper[5].

Multi-Strategy funds, as would be expected, have exposure to (at least) two asset classes: stocks and commodities. Although the return variance explained by the risk factors is quite high, this classification would benefit from a subclass examination. The author writes this because multi-strategy mutual funds are often a combination of other alternative-investment strategies. Therefore, our use of the classification as a whole only begins to open the door on the variety of risk factors that could explain multi-strategy fund returns.

As Table 1 shows, much of the return variance of alternative investment classifications can be explained via standard and nonstandard risk factors, i.e., these funds are capturing traditional and alternative beats primarily. And what about alpha? Only Equity Market-Neutral funds as a group have a statistically significant positive alpha. Over the course of a year that alpha could be as high as 2.5%. Other classifications tend to have a (not statistically significant) positive alpha.  And given the limitations on leverage 40Act managers face, they cannot, like their hedge fund brethren, use enough leverage to achieve a measurable alpha.

In our next article we will look at the possibility of building benchmarks for individual alternative-investment funds.