The global financial crisis, the resulting volatility and the resultant, long lasting psychological effects have changed the way the world views the global investment opportunity set. Investors of all types and sizes seek diversifying strategies which will assist them in bolstering returns and reducing risk. Given this appetite, where are they to turn? 

Still a small proportion of U.S. mutual fund assets and total number of funds, alternative strategies delivered in registered structures have and will continue to account for an ever-increasing percentage of new fund offerings and asset inflows. Alternative strategies asset flows into U.S. mutual funds and ETFs accounted for $39 billion in net inflows in the first eight months of 2011 and are on pace to come close to 2010’s total of $65 billion. By August of 2011, the U.S. had close to 730 alternative mutual funds and ETFs, of which 118 were launched in the first eight months of this year1

Why are alternative mutual funds and ETFs garnering such growth in sheer numbers and in asset inflows? Simple…investors of all sizes can now access the same strategies where only institutions and accredited investors once roamed. Unlike their hedge fund cousins, alternative strategies delivered in registered structures offer the advantages of liquidity, transparency, daily valuation, simplified fee structures and regulatory reporting. In short, the ability to diversify one’s portfolio using alternative, non-correlated strategies in a cost effective manner is now available to the masses.
Hypothetical Portfolio Example
To illustrate the potential risk/return benefits of adding alternative mutual funds to a well-diversified portfolio we ran two hypothetical portfolios through the Highland/Morningstar X-Ray portfolio analysis tool. Included in this analysis is the presentation of risk/return characteristics over a period of time from May of 2008 (inception of the Highland Long/Short Healthcare Fund) through December of 2011. 

We ran the first portfolio with 50% traditional fixed income products and 50% traditional equity products. We then took the same portfolio and replaced half of equity and fixed income products with two Highland Alternative products (Highland Long/Short Equity and Highland Long/Short Healthcare), resulting in a 33% allocation to each Equity, Fixed Income and Alternative Asset classes.  A summary of important risk/return characteristics for each portfolio along with an explanation of each risk/return measurement are summarized below. 

Modern Portfolio Theory risk/return measurements used when evaluating a portfolio
– Measures a manager’s contribution to performance due to security selection or market timing relative to the index. The higher the Alpha measurement, the more the manager’s security selection skill has added to performance. The lower the Alpha measurement, the less the manager’s security selection skill has added to performance.Beta – the covariance of manager and benchmark divided by the variance of the benchmark. Beta is a measure of systematic risk, or the sensitivity of a manager’s security choices to movements in the benchmark. A beta of 1 implies that you can expect the movement of a manager’s return series to match that of the benchmark used to measure beta. (The lower, the lower amount of correlation to the market). A Beta measurement greater than 1 implies that the portfolio manager’s return series should be more volatile than the market. A Beta measurement less than 1 implies that the portfolio manager’s return series should be less volatile than the market.Drawdown – the peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted as the percentage drop in the fund between the peak and the trough. Drawdowns help determine an investment’s financial risk. Lower historical drawdown measurements are preferred to higher historical drawdown measurements.Sharpe Ratio – a measure that uses standard deviation and excess return to determine reward per unit of risk. Higher sharpe ratios imply more units of return per units of risk employed. Higher Sharpe Ratios are preferred to lower Sharpe Ratios.Standard Deviation – standard deviation of returns measures the average a return series deviates from its mean. It is often used as a measure of risk. Higher standard deviation represents higher volatility and therefore implies more risk. Lower Standard Deviation measurements are generally preferred to higher Standard Deviation measurements.R-Squared – a measure that indicates the extent to which fluctuations in portfolio returns are correlated with those of the index. Higher R-Squared measurements imply a strong relationship between the portfolio manager’s security selections and the movements of securities present in a stated benchmark. Lower R-Squared measurements imply a lesser relationship between the movements of the portfolio manager’s security selections and the movements of securities present in a stated benchmark. Lower R-Squared measurements are preferred to higher R-Squared measurements when one is seeking active management and returns that will be different that than those of the stated benchmark.

The full Morningstar report are available here.  There are important disclosures contained within these reports along with more complete performance information.

Link to full X-Ray portfolio report with Alternative Strategies

Link to full X-Ray portfolio report without Alternative Strategies

1SEI, Regulated Alternative Funds: The New Conventional