6. Past Performance Is No Guarantee, But Still Nice To Have.
Past performance is no guarantee of future returns, but it is helpful to see how a fund has performed in the past. Because so many alternative mutual funds have come out in recent years, many don’t have a five-year or even a three-year track record. Some funds with shorter track records offer historical performance from either a similar institutional strategy or back-tested data. But a strategy in a mutual fund may be very different from an institutional strategy because there are limits on illiquid investments, limits on leverage and diversification requirements, to name just a few potential differences. It’s important to understand the differences before you can determine whether the institutional track record is applicable to the fund strategy. Also, it is good to confirm that the performance data is actual live data and not back-tested data. Back-tested data always looks good! If the institutional strategy is very similar to the fund’s, you can be comfortable analyzing it.
7. Consider Market Cycle Performance In Standard Time Periods.
In addition to looking at performance over the standard one-, three- and five-year time periods, it is important, especially with alternative strategies, to review how funds perform during different parts of the market cycle. We like to review performance from the peak of the market to the trough, from the trough to the peak, and over the full market cycle. Standard one-, three- and five-year time frames may all take place during a bull market, giving you only half the story.
8. Consider Risk-Adjusted Performance.
Within alternatives, more so than in traditional stocks and bonds, strategies may be run with more or less risk, and you need to account for that when comparing strategies. For example, one long/short equity strategy may typically be 40% net long and another 20%. Using risk-adjusted performance measures such as the Sharpe ratio is helpful when comparing managers with different risk characteristics.
9. Consider The Correlation To Stock And Bond Markets.
Part of the appeal of alternative investments is the diversification they offer apart from traditional stock and bond markets. But it’s important to consider how correlated each alternative investment is to those markets and how much diversification it will provide to the portfolio. Those correlations may change over time as well. For example, managed futures strategies may have a positive correlation to stocks during bull markets and a negative one during bear markets.
10. Don’t Forget Taxes And Expenses.
Alternative mutual funds are often less tax-efficient and often have higher expenses than traditional stock and bond mutual funds. It may make sense to buy an alternative fund in a tax-deferred account, but if the fund will be in a taxable account, evaluate the after-tax returns. When you review expenses, remember that some alternative mutual funds are funds of funds and have two layers of management fees. Funds that short stocks as part of their investment strategy will have to pay short interest and dividend expenses in addition to management fees. When considering alternative mutual funds, review the components of the expenses to understand them and look for lower fee options that are less of a hurdle for a manager to overcome.
Now that they are seven years into a bull market facing extremely low bond yields, investors’ attraction to alternative mutual funds would be understandable. However, the proliferation of these funds in recent years makes thorough research and due diligence by advisors and investors even more important if they are to select strategies that will be a good fit for them.
Don Wilson is a partner and the chief investment officer at Brightworth, an Atlanta wealth-management firm with $1.2 billion in assets under management.