Investment Focus - Segal · PDF fileconsultant or one of the following ... To receive issues...

Investment Focus n December 2014

2

Table of Contents What Are Alternative Strategies and Why Do They Matter? ................................................................ 1

How Has the Hedge Fund Industry Evolved? .......................................................................................... 1

Defining the Alternative Mutual Fund Universe ........................................................................................ 3

Structural Comparison: Alternative Mutual Funds versus Hedge Funds ........................................... 5

Performance Comparison ............................................................................................................................. 8

Implementation Considerations ................................................................................................................12

Conclusion .....................................................................................................................................................13

Questions? Contact Us.

For more information about liquid alternative strategies, contact your Segal Rogerscasey Canada consultant or one of the following investment professionals:

Segal Rogerscasey Canada provides investment solutions and consulting advice to corporations, plan sponsors and retail clients across Canada. For more information about the firm, visit http://www.segalrc.com/canada/.

To receive issues of Investment Focus and other Segal Rogerscasey Canada publications as soon as they are available online, register your e-mail address via http://www.segalrc.com/register/.

Segal Rogerscasey Canada is a member of The Segal Group (www.segalgroup.net), which is celebrating its 75th anniversary this year, and the Global Investment Research Alliance (http://www.gir-alliance.com/).

Kathleen Pabla 416.642.7791 [email protected]

Charles Colfer 203.621.3636 [email protected]


1

Liquid Alternatives — Alternative Mutual Fund Primer

The terms “alternative strategies” or “alternatives” have historically been associated primarily with hedge fund and private market investments, which can include private equity, real estate and hard

assets. These strategies can provide better absolute performance or portfolio diversification, but they also typically come with a restriction on liquidity and a high cost structure that puts them out of reach for many individual investors.

Another type of alternative investment option known as the liquid alternative has proliferated in recent years. These strategies aim to provide similar diversification and return characteristics as hedge fund and private market investments — but with greater liquidity and lower minimum investment require-ment. As such, liquid alternatives are providing investors access to an asset class that in the past was only available to qualified high-net-worth individuals and institutions.

As the liquid alternatives universe continues to expand and attract assets, it is important to shed more light on these strategies. One segment of the universe that has attracted particular attention from the investment community of late has been alternative mutual funds that attempt to pursue hedge fund strategies. This issue of Investment Focus will discuss these alternative mutual funds, providing an overview and comparing them to the hedge fund strategies they emulate.

What Are Alternative Strategies and Why Do They Matter?Alternative strategies have several characteristics that make them different from and, as the name suggests, alternatives to traditional long-only investments. Alternative strategies generally provide a number of diversifying benefits such as risk mitigation, low or imperfect correlations, and return

enhancement, to a portfolio of long-only investments. They also have more flexible, or less constrained, mandates that enable them to tap sources of return generally not available to long-only equity and fixed income managers. While comparing alternative investments to long-only benchmarks may result in significant tracking error, the benefits of investing in alternatives, including hedge fund strategies, can include improved risk-adjusted and absolute returns.

Liquid alternative strategies are designed to provide a portfolio with benefits similar to those offered by hedge fund strategies. However, whereas hedge funds are generally unconstrained, liquid alterna-tives in the form of U.S. mutual funds are subject to the regulations of the Investment Company Act of 1940 (the ’40 Act), including strict rules regarding liquidity, leverage, fees and disclosures.

How Has the Hedge Fund Industry Evolved?It is useful to review some background information on the hedge fund industry to gain a better under-standing of the liquid alternatives universe. The earliest hedge fund strategy dates back to the 1940s, when Alfred Winslow Jones combined leveraged long stock holdings with a portfolio of short posi-tions. Over the years, the hedge fund industry has grown, enjoying a significant boom in the early- to mid-2000s, when assets nearly tripled from around $500 billion USD to close to $1.5 trillion USD. The industry suffered a brief setback during the financial crisis of 2007–2008, but it quickly recovered and has experienced new growth records year over year over the last three years, with current total assets of hedge funds at $2.8 trillion USD as of September 30, 2014, according to Hedge Fund Research, Inc. (HFR). Similarly, the number of funds has increased in the last decade and now totals about 10,000.

“ The benefits of investing in alternatives, including hedge fund strategies, can include improved risk-adjusted and absolute returns.”


2

In comparison, the alternative mutual fund universe is relatively young and thinly populated. Morn-ingstar’s Alternative Global Broad Category Group currently includes 1,559 share classes and 470 distinct strategies classified as “Alternative.” Notably, 29 of these strategies launched prior to September 30, 1999; 99 strategies launched prior to September 30, 2004; and 195 launched prior to September 30, 2009. This translates to 6.2 percent of the universe having at least a 15-year track

record, 21.1 percent having at least a 10-year track record, and 41.5 percent having at least a five-year track record. Although com-paratively small in size and number, the data indicates that this area of the market has seen tremendous growth over the last five years. Of note, some 44.0 percent of the Morningstar’s Alternative Global Broad Category Group launched in the last three calendar years, and expectations are for it to continue to experience significant growth.

Current assets managed within Morningstar’s Alternative Global Broad Category Group total approximately $775 billion USD, just over 25 percent of hedge fund assets. However, the annual growth rate over the last five years within the Morningstar Alternative Global Broad Category Group has been in excess of 30 percent, while the compound annual growth rate (CAGR) for the hedge fund indus-try over the same period has been around 15 percent, according to Morningstar and HFR. The growth in alternative mutual funds is likely a result of two factors: retail investors looking to diversify their portfolios after the crisis of 2007–2008 and investment managers

launching new products that aim to provide similar characteristics to hedge fund strategies, but with increased liquidity and lower minimum investment. Graphs 1 and 2 below show a comparison of current assets under management and current number of strategies, respectively, in the alternative mutual fund and hedge fund universes.

“ The growth in alternative mutual funds is likely a result of two factors: retail investors looking to diversify their portfolios after the crisis of 2007–2008 and investment managers launching new products that aim to provide similar characteristics to hedge fund strategies, but with increased liquidity and lower minimum investment.”

Graph 1: Current Assets Under Management, as of September 30, 2014

Sources: Hedge Fund Research and Morningstar

Graph 2: Number of Funds/Number of Strategies, as of September 30, 2014


0

2,400

4,800

7,200

9,600

12,000

0

$600

$1,200

$1,800

$2,400

$3,000

$775

$2,819

1,559

10,119

0

2,400

4,800

7,200

9,600

12,000

0

$600

$1,200

$1,800

$2,400

$3,000

$775

$2,819

1,559

10,119

Alternative Mutual Funds

Alternative Mutual Funds

Hedge Funds

Hedge Funds

Mill

ions

(U

SD

)


3

Defining the Alternative Mutual Fund UniverseThe liquid alternative universe includes a selection of products and vehicles, ranging from alternative exchange-traded funds (ETFs) and Undertakings for the Collective Investment of Transferable Secu-rities (UCITS)1 products, to mutual funds compliant with the Investment Company Act of 1940

(’40 Act funds). However, for the purposes of this publication, Segal Rogerscasey analyzed only U.S. mutual funds that invest in strategies historically executed primarily by hedge fund manag-ers. We used the Morningstar universe of mutual funds, focusing on the open-ended funds. The universe of open-ended U.S. mu-tual funds currently includes just fewer than 29,000 funds, and 1,559 of those are classified as “Alternative” by Morningstar.

For the purposes of our analysis, Segal Rogerscasey created custom groupings of alternative mutual funds that resemble

respective hedge fund strategy indices as closely as possible. Additionally, our analysis includes a single share class from each respective strategy (in order to eliminate diluting the data by includ-ing all share classes offered by a manager), differentiated only by the level of fees. We considered all institutional share classes, where available, and selected the share class with the lowest fees in all cases where an institutional share class was not available. Table 1 below shows Segal Rogers-casey’s category groupings.

We omitted categories that we do not consider extensions of hedge fund strategies, as well as several categories that have very few members (typically less than 10). We also excluded catego-ries that have too narrowly defined a mandate, such as sector-focused strategies. Conversely, we included funds that fall under the Morningstar Fixed Income Global Broad Category (a primarily traditional/long-only fund category); Non-Traditional Bond funds and Long/Short Credit funds, as these exhibit similar characteristics to Event Driven/Credit hedge fund strategies. As shown in Table 1 above, three categories include funds that have a single-strategy focus, while the Multi- alternative category includes funds that invest in multiple strategies, either as multi-strategy funds under a single adviser or by employing multiple sub-advisers, such as manager-of-managers/fund-of-funds products.

1 UCITS is a public limited company that coordinates the distribution and management of unit trusts amongst countries within the European Union.

Table 1: Segal Rogerscasey’s Custom Peer Groupings of Morningstar Alternative Mutual Funds

Name of Grouping (Peer Group) Number of Distinct Strategies

Equity Long/Short • Equity Long/Short, Bear Market, Equity Market Neutral 151

Event Driven/Credit • Event Driven, Long/Short Credit, Non-Traditional Bond 107

Global Macro • Managed Futures, Currency 63

Multialternative 118

“ For the purposes of our analysis, Segal Rogerscasey created custom groupings of alternative mutual funds that resemble respective hedge fund strategy indices as closely as possible.”


4

Single-Strategy Funds

Our universe of single-strategy alternative mutual funds includes the Equity Long/Short, Event Driven/Credit and Global Macro category groupings. While these include sub-categories, broad definitions of the hedge fund strategies they employ are listed below.2

Equity Long/Short maintains positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment deci-sion, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. Equity long/short managers would typically maintain at least 50 percent exposure to, and may in some cases be entirely invested in, equities, both long and short.

Event Driven/Credit maintains positions in companies currently or prospectively involved in cor-porate transactions of a wide variety, including, but not limited to, mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event driven/credit exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company-specific developments. Investment theses are typically predicated on fundamental char-acteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.

Global Macro trades a broad range of sub-strategies in which the investment process is estab-lished on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top-down and bottom-up theses, quantitative and fundamental approaches and long- and short-term holding periods. Although some strategies employ relative value techniques, global macro strategies are distinct from relative value strategies in that the primary investment thesis is centered on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both global macro and equity long/short managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposed to equity long/short, in which the fundamental characteris-tics of the company are the most significant and integral to investment thesis.

Multialternative Funds

Multialternative funds typically invest in two or more underlying strategies, which can be managed either in-house by the investment manager or outsourced to sub-advisors. Internally managed multialternative funds generally invest in multiple strategies that classify as one of the individual strategies discussed in the single-strategy funds section. The multialternative category of funds has seen a recent uptick in new products coming to market with the emergence of the ’40 Act funds of funds, which are typically managed by providers of hedge-fund-of-funds vehicles that have structured their products to comply

with the law’s mutual fund requirements.

A multi-manager fund (also known as fund of funds) is designed to be diversified portfolios with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The investment manager has discretion in choosing which strategies to invest in for the

portfolio. Funds may be allocated to numerous sub-advisers within a single strategy, or with numerous managers in multiple strategies. Investors gain diversification among managers and styles by investing significantly less capital than they would by making direct investments with the separate managers.

2 These definitions are from Hedge Fund Research, Inc.

“ The multialternative category of funds has seen a recent uptick in new products coming to market.”


5

“ Because investors face high barriers to entry, hedge funds have historically only been accessible to high-net-worth individuals and institutions.”

“ The low investment minimum requirement of alternative mutual funds allows essentially all investors to gain alternative exposure.”

Structural Comparison: Alternative Mutual Funds versus Hedge FundsInvestor Qualifications

Investors face much higher barriers to entry with hedge funds than with alternative mutual funds. Hedge funds are not required to comply with the 1934 Securities Exchange Act, which initially required a fund with more than 499 investors to register with the SEC, through an exemption granted in the Investment Advisor Act of 1940. As a result, investors in hedge funds must qualify for Accredited Investor or Qualified Purchaser status, which eliminates the protection provided by government filings for financially sophisticated investors. This is one of the largest hurdles that individual/retail investors face in accessing hedge funds and other alternative products. Accredited Investors, typically individuals, must possess a certain level of net worth. In the U.S., individual Accredited Investors must have at least $1 million USD in net worth, excluding their primary resi-dence, or income of at least $200,000 USD in each of the last two years and an expectation to make at least the same amount in the current year. For a household, the income threshold increases to $300,000 USD. Meanwhile, the Qualified-Purchaser requirement presents an even higher hurdle for individuals, and therefore typically pertains to institutional investors. For an individual to be a Qualified Purchaser he/she needs to own at least $5 million USD in investments, not including real estate held for personal purposes, jewelry, art, antiques and other collectibles. Debt used to acquire these investments is excluded from this value. For institutions, the minimum value of investment assets is $25 million USD.

Because investors face high barriers to entry, hedge funds have historically only been accessible to high-net-worth individuals and institutions. However, the emergence of alternative mutual funds presents access to a subset of hedge fund strategies to all investors. As with other mutual funds, the high level of regulatory oversight makes this wider access possible. Furthermore, not only can the U.S. retail market use alternative mutual funds, but so can the retirement market, such as individual retirement accounts (IRAs), annuity reserves and defined con-tribution plans. Relative to hedge funds, the low-qualification hurdle makes alternative mutual funds a more broadly accessible and attractive option.

Investment Limitations

While the low investment minimum requirement of alternative mutual funds allows essentially all investors to gain alternative exposure, the mutual fund structure itself limits investment managers’

ability to execute certain strategies that U.S. regulatory agencies may perceive as either excessively risky or highly speculative. This is a major point of differentiation between hedge fund strategies and alter-native mutual funds: The mandates pursued by hedge fund strategies may differ from those that alternative mutual fund strategies pursue within the confines of the ’40 Act. Driving this disparity are the ’40 Act’s rules regarding liquidity, leverage and the use of derivatives to which alternative mutual funds must adhere.

With regard to liquidity, mutual funds registered under the ’40 Act are required to provide daily liquidity as well as cash for redemption requests within seven days, with a typical settlement date of T+3 days.3 In comparison, hedge fund strategies typically have more onerous liquidity terms, with redemption frequencies generally ranging from monthly to semi-annually or annually. Quarterly redemption frequency is the most common and is generally subject to 30 or 60 days’ prior written notice. Additionally, many hedge fund vehicles have an initial lock-up period during which investor redemptions are not permitted. Ultimately, hedge funds do not have to worry about the daily valua-tions and capital fluctuations that alternative mutual funds are subject to, and can therefore execute

3 Trade date plus three days.


6

strategies with medium- to longer-term theses in place. U.S. mutual fund regulations also dictate that no more than 15 percent of a fund’s net asset value may be invested in illiquid securities, such as certain debt and credit instruments and/or private issues. Therefore, the mutual fund structure

does not lend itself to strategies that require a certain level of flexibility around investing in less-liquid or illiquid instruments, such as distressed debt, which has historically been one of the top-performing hedge fund strategies. Given these differences, we expect that the longer-term nature of hedge fund mandates and the ability to invest in less-liquid securities may provide the enhanced opportunity to outperform more-liquid alternatives depending on the market cycle.

The use of leverage has historically been one of the key compo-nents contributing to hedge-fund returns. Most hedge funds use modest levels of leverage, if any leverage at all. However, there are certain fixed-income and global macro strategies that take

advantage of narrow price differentials and use greater levels of leverage to increase exposure and absolute returns. In general, there are no limitations as to how much leverage any particular hedge fund can use; most sophisticated investors generally shy away from strategies and funds that use ex-cessive levels of financing in order to generate returns. In contrast, U.S. mutual fund regulation limits the use of leverage to no more than 33 percent of the fund’s assets, including short sales, swaps, options and other derivative instruments. As such, this requirement can either exclude certain hedge fund strategies from a mutual fund framework or lower the expectations for return generation from strategies that would normally use higher levels of leverage. There are a number of strategies, includ-ing equity long/short, which are generally executed with less leverage and can be managed in a mutual fund framework with similar characteristics; however, leverage limitations present a challenge for other strategies and should inherently limit the outcome from alternative mutual fund products executing such strategies.

Lastly, regulation in the U.S. limits derivatives trading by mutual funds. While hedge funds typically have a wide range of options when it comes to expressing trade ideas, alternative mutual funds are subject to stricter oversight. One area where this is particularly onerous for alternative mutual funds is commodities trading (which often relies on derivatives trading). Because these investments may result in additional taxation for the mutual fund, managers are generally forced to set up offshore blockers in order to trade commodities or tend to avoid commodity investments in general. This obviously affects certain strategies negatively by making it difficult to execute trades effectively.

Fees

Given their relative complexity, the fees that alternative investments such as hedge funds charge have historically been higher than those charged by long-only or traditional equity and fixed income investments. However, long-term historical results indicate that alternative investments add value to a portfolio, justifying paying higher fees for such allocations.

Hedge fund fees typically average in the range of a 1.5 percent to 2.0 percent management fee and a 20 per-cent performance fee. We have observed a reduction in the standard fees over the last several years, particularly sub-sequent to the financial crisis in 2007–2008. The reduction in fees has typically come in exchange for somewhat more stringent liquidity terms. Hedge fund vehicles typically offer quarterly redemption rights, with some cases of monthly redemptions, and others offer as few as annual redemption windows.

“ The mutual fund structure does not lend itself to strategies that require a certain level of flexibility around investing in less liquid or illiquid instruments, such as distressed debt, which has historically been one of the top-performing hedge fund strategies.”

“ Given their relative complexity, the fees that alternative investments such as hedge funds charge have historically been higher than those charged by long-only or traditional equity and fixed income investments.”


7

While alternative mutual funds have the same fee structures relative to their broader market mutual fund counterparts (management fee plus expenses, but no performance fee), their price points are generally much higher. The typical net expense ratios (management fees plus expenses) for equity and bond mutual funds may range from 30 basis points to 150 basis points. Meanwhile, alternative mutual funds are priced higher, with an average annual net expense ratio of 169 basis points, includ-ing an average management fee of 104 basis points. Additionally, the average prospectus expense is 202 basis points. In order to provide additional comparison, Table 2 below shows the breakdown of fees and expenses for hedge funds versus alternative mutual funds. Importantly, while hedge fund vehicles typically charge a performance-based fee on top of a management fee, the mutual fund structure does not allow managers to charge a performance fee.

Assuming a $1 million USD investment at a 10 percent gross return, Table 3 below illustrates the fees attributable to the various strategies on a dollar basis.

Table 2: Fee Comparison: Hedge Funds Versus Alternative Mutual Funds

Strategy Name Hedge Funds Alternative Mutual Funds

Management Fee Performance Fee Management Fee Net Expense Ratio**

Equity Long/Short 1.0%–2.5% 20%–30% 0%–2.3% 0.1%–4.2%

Event Driven/Credit 1.5%–2.0% 15%–20% 0%–2.5% 0%–3.8%

Global Macro 1.0%–3.0% 20%–30% 0%–3.0% 0.6%–3.4%

Multialternative* 2.0%–4.0% 30%–40% 0.75%–1.2% 0.3%–4.2%

* The Multialternative category under the hedge funds moniker represents typical fund of hedge funds fees of 1 percent management and 10 percent performance, in addition to the management and performance fees (2 percent and 20 percent, respectively) charged by the underlying managers.

** Net Expense Ratio is encompassing of the management fee.


Table 3: Fee Comparison: Hedge Funds Versus Alternative Mutual Funds (USD)

Strategy Name Hedge Funds Alternative Mutual Funds

Management Fee

Performance Fee

Combined/ Net Fee

Management Fee

Net Expense Ratio**

Equity Long/Short$10,000–$25,000

$20,000–$30,000

$30,000–$55,000

$0– $23,000

$1,100– $46,000

Event Driven/Credit $15,000–$20,000

$15,000–$20,000

$30,000–$40,000

$0– $25,000

$0– $41,800

Global Macro$10,000–$30,000

$20,000–$30,000

$30,000–$60,000

$0– $30,000

$6,600– $37,400

Multialternative*$20,000–$40,000

$30,000–$40,000

$50,000–$80,000

$7,500–$12,000

$7,500– $46,200

* The Multialternative category under the hedge funds moniker represents typical fund of hedge funds fees of 1 percent management and 10 percent performance, in addition to the management and performance fees (2 percent and 20 percent, respectively) charged by the underlying managers.

** Net Expense Ratio is encompassing of the management fee.



8

Tax Implications

Tax reporting is an area where alternative mutual funds present an advantage relative to hedge funds. Hedge funds are registered as limited partnerships or limited liability companies, which have no tax liability at the entity or fund level. Investors must report their proportionate share of the fund’s gains and losses on their individual tax returns and pay taxes on items reported as income or gain on a K-1 form provided by the fund. This process is typically arduous for individual investors because they often have to file extensions with the IRS due to the complexity of the reporting process as well as the timing of the receipt of their K-1 forms, which tend to arrive between March and June. K-1 forms are issued subsequent to the completion of an audit, which causes them to lag the traditional tax-reporting season.

Alternative mutual fund investors, meanwhile, are subject to the same tax implications as other mu-tual fund investors. Generally, U.S. federal and state income taxes are assessed on dividends as well as capital gains. There are two types of transactions subject to taxation: distributions from the fund and the sale of the fund’s shares. Because mutual funds typically send distributions at the end of a calendar year, investors receive reporting statements during the regular tax season, making it easier to report their tax obligations to the IRS.

Performance ComparisonReturn Analysis

Table 4 below includes historical performance statistics comparing Segal Rogerscasey’s custom alternative mutual fund groupings with their hedge fund counterparts (as measured by the corre-sponding HFRI indices). In order to eliminate a significant skew, we used the Morningstar universe of funds to create historical track records for each alternative mutual fund category that begin when the category included at least 10 member funds/individual strategies. Additionally, we included only one share class of the member fund/individual strategy in the performance track record — generally either the institutional share class or, in the absence of an institutional share class, the share class with the lowest fees. It is important to keep in mind that not all investors will be eligible for these returns, as higher fees and expenses may erode additional returns for certain alternative mutual fund investments. For comparison purposes, we also included the performance of the S&P 500® Index, the MSCI World Index and the Barclays U.S. Aggregate Index over the one-, two-, three-, four- and five-year periods as of September 30, 2014.

Table 4: Five-Year Return Analysis, as of September 30, 2014

1 Year 2 Years 3 Years 4 Years 5 Years

Equity Long/Short 4.66% 4.85% 5.27% 4.01% 3.71%

HFRI Equity Hedge Index 6.70% 8.91% 8.41% 5.15% 5.44%

Event Driven/Credit 3.57% 3.24% 4.93% 3.84% 4.94%

HFRI Event Driven Index 6.69% 9.40% 8.56% 6.30% 7.26%

Global Macro 4.71% 0.74% -0.09% 0.42% 0.77%

HFRI Macro Index 5.66% 1.18% 0.45% 0.88% 1.41%

Multialternative 4.54% 3.84% 4.71% 3.56% 3.84%HFRI Fund Weighted Composite Index 6.66% 6.83% 6.46% 4.54% 5.10%

S&P 500® Index 19.73% 19.54% 22.99% 17.12% 15.70%

MSCI World Index 12.80% 16.78% 18.60% 12.54% 11.47%

Barclays U.S. Aggregate Index 3.96% 1.10% 2.43% 3.13% 4.12%



9

Relative to the S&P 500® and the MSCI World indices, both hedge funds and alternative mutual funds have significantly under-performed, on average, over the past five years. Over this same period, hedge fund strategies, on average, outperformed their alternative mutual fund counterparts. Most notably, Event Driven/Credit and Equity Long/Short hedge funds provided the greatest outperformance. The HFRI Event Driven Index outperformed its alternative mutual fund counterpart by approximately 232 basis points. Similarly, the HFRI Equity Hedge Index outperformed the alternative mutual fund Equity Long/Short strategy grouping by more than 173 basis points over the trailing five-year period. Meanwhile, the HFRI Fund Weighted Composite Index outper-formed the alternative mutual fund Multialternative strategy

grouping by 126 basis points over the same period. Finally, the HFRI Macro Index trailing five-year return outpaced the return of the alternative mutual fund Global Macro strategy grouping over the same period. The HFRI Macro Index outgained the alternativemutual fund Global Macro strategy grouping by approximately 64 basis points.

Beta Analysis

Table 5 below shows that, over the past five years, the alternative mutual fund Equity Long/Short and Event Driven/Credit groupings exhibited roughly half the beta to the S&P 500®, MSCI World and Barclays U.S. Aggregate indices relative to their hedge-fund counterparts, the HFRI Equity Hedge Index and the HFRI Event Driven Index. Meanwhile, there was less disparity between the alternative mutual fund Global Macro and Multialternative groupings and their hedge-fund counterparts. How-ever, both of these alternative mutual fund strategy groupings produced roughly the same beta to the S&P 500® Index and the MSCI World Index. Next, the alternative mutual fund Global Macro grouping exhibited a slightly greater beta to the Barclays U.S. Aggregate Index than the HFRI Macro Index. Finally, the HFRI Fund Weighted Composite Index produced a lower beta to the same index, than did its alternative mutual fund counterpart.

Table 5: Five-Year Beta Analysis, as of September 30, 2014

S&P 500® IndexMSCI

World IndexBarclays U.S.

Aggregate Index

Equity Long/Short 0.28 0.25 -0.33

HFRI Equity Hedge Index 0.53 0.50 -0.68

Event Driven/Credit 0.14 0.14 0.01

HFRI Event Driven Index 0.33 0.31 -0.47

Global Macro 0.16 0.15 0.28

HFRI Macro Index 0.15 0.15 0.24

Multialternative 0.34 0.32 -0.18

HFRI Fund Weighted Composite Index 0.35 0.33 -0.32


“ Relative to the S&P 500® and the MSCI World indices, both hedge funds and alternative mutual funds have significantly underperformed, on average, over the past five years. Over this same period, hedge fund strategies, on average, outperformed their alternative mutual fund counterparts.”


10

Correlation Analysis

Table 6 below shows that, over the past five years, alternative mutual funds and hedge fund indices have proven to be highly correlated. The alternative mutual fund Equity Long/Short and Event Driven/Credit strategy groupings have exhibited correlations of 0.95 and 0.89 to their respective hedge-fund counterparts. Next, the alternative mutual fund Multialternative grouping produced a correlation of 0.95 to the HFRI Fund Weighted Composite Index. Meanwhile, the alternative mutual fund Global Macro group of funds produced a correlation of 0.88 to the HFRI Macro Index.

Volatility Analysis

Table 7 on the next page shows that, over the past five years, the alternative mutual fund Equity Long/Short grouping has produced roughly two-thirds the returns of the HFRI Equity Hedge Index, with approximately half the volatility (as measured by standard deviation). As a result, Sharpe ratios for the two groups of funds are similar. Meanwhile, over the same period, the alternative mutual fund Event Driven/Credit peer group returned roughly 32 percent less than the HFRI Event Driven Index, with about half the volatility. The result is a Sharpe ratio4 of 1.85 versus 1.39 for the alternative mutual fund Event Driven/Credit groupings compared to the HFRI Event Driven Index. Elsewhere, the HFRI Fund Weighted Com-posite Index outperformed alternative mutual fund Multialternative grouping by roughly 125 basis points with a slightly greater risk profile over the five-year period. Finally, over the same period, the HFRI Macro Index outperformed the HFRI Macro Index by over 60 basis points, with a slightly greater standard devia-tion than its alternative mutual fund counterpart. This resulted in a Sharpe Ratio of 0.32 and 0.19 for the HFRI Macro Index and alternative mutual fund Global Macro grouping, respectively.

4 Sharpe ratio is a measure of risk-adjusted performance; calculated by taking the excess return above a risk-free rate divided by standard deviation.

Table 6: Five-Year Correlation Analysis, as of September 30, 2014

Equ

ity L

ong/

Sho

rt

HFR

I Equ

ity

Hed

ge In

dex

Eve

nt D

riven

/Cre

dit

HFR

I Eve

nt

Driv

en In

dex

Glo

bal M

acro

HFR

I Mac

ro In

dex

Mul

tialte

rnat

ive

HFR

I Fun

d W

eigh

ted

Com

posi

te In

dex

S&

P 5

00® In

dex

MS

CI W

orld

Inde

x

Bar

clay

s U

.S.

Agg

rega

te In

dex

Equity Long/Short 1.00

HFRI Equity Hedge Index 0.95 1.00

Event Driven/Credit 0.75 0.83 1.00

HFRI Event Driven Index 0.88 0.95 0.89 1.00

Global Macro 0.47 0.47 0.43 0.44 1.00

HFRI Macro Index 0.42 0.47 0.39 0.42 0.88 1.00

Multialternative 0.93 0.92 0.81 0.88 0.67 0.62 1.00

HFRI Fund Weighted Composite Index 0.92 0.98 0.85 0.95 0.60 0.62 0.95 1.00

S&P 500® Index 0.96 0.92 0.73 0.85 0.52 0.45 0.94 0.89 1.00

MSCI World Index 0.94 0.94 0.79 0.88 0.55 0.47 0.95 0.92 0.97 1.00

Barclays U.S. Aggregate Index -0.24 -0.25 0.01 -0.26 0.20 0.15 -0.11 -0.18 -0.25 -0.19 1.00



Up/Down Market Capture Analysis

Table 8 below shows that, over the five-year period analyzed, the alternative mutual fund Equity Long/Short strategy captured roughly 42 percent less than the HFRI Equity Hedge Index in up markets and about 50 percent less in down markets. Similarly, the alternative mutual fund Event Driven/Credit grouping captured about 50 percent less of up market returns than the HFRI Event Driven Index. However, in down markets, the alternative mutual fund Event Driven/Credit grouping captured roughly 70 percent less of the return. Meanwhile, alternative mutual fund Global Macro and Multialternative groupings captured roughly the same return in both up and down markets as the HFRI Macro Index and the HFRI Fund Weighted Composite Index, respectively. Based on the up and down market captures of Equity Long/Short and Event Driven/Credit HFR indices versus their alternative mutual fund grouping counterparts, it seems fair to suggest that some of the tools avail-able to hedge fund strategies, such as the use of leverage and less-stringent illiquidity thresholds, are beneficial in up markets but detrimental in down markets. As it pertains to manager selection, it is important to monitor the utilization of alterative management tools that both hedge fund and alterna-tive mutual fund managers have at their disposal.

Table 7: Five-Year Volatility Analysis, as of September 30, 2014

Return Standard Deviation Sharpe Ratio

Equity Long/Short 3.71% 3.84 0.95

HFRI Equity Hedge Index 5.44% 7.55 0.73

Event Driven/Credit 4.94% 2.59 1.85

HFRI Event Driven Index 7.26% 5.09 1.39

Global Macro 0.77% 3.99 0.19

HFRI Macro Index 1.41% 4.47 0.32

Multialternative 3.84% 4.71 0.81HFRI Fund Weighted Composite Index 5.10% 5.17 0.97

S&P 500® Index 15.70% 13.09 1.18

MSCI World Index 11.47% 14.24 0.83

Barclays U.S. Aggregate Index 4.12% 2.81 1.42


Table 8: Five-Year Up/Down Market Capture Analysis, as of September 30, 2014

Up Market Capture Down Market Capture

Equity Long/Short 27.7% 32.6%

HFRI Equity Hedge Index 47.5% 62.3%

Event Driven/Credit 22.0% 9.8%

HFRI Event Driven Index 39.8% 31.5%

Global Macro 12.6% 22.0%

HFRI Macro Index 14.0% 19.7%

Multialternative 31.3% 39.4%

HFRI Fund Weighted Composite Index 35.5% 38.8%


11


12

Implementation ConsiderationsRisk and Return Expectations

While alternative mutual funds aim to position themselves as mimicking hedge fund strategies, they face a number of structural hurdles potentially preventing them from achieving the same risk and return characteristics. As such, the expectations for investors looking to invest in alternative mutual funds should be adjusted accordingly. In general, expectations are for hedge fund strategies to produce greater returns, with greater risk, as they are less constrained in their use of leverage and illiquid investments. Based on the five-year performance discussed earlier, alternative mutual funds,

on average, have delivered roughly two thirds of the returns, while also taking approximately two thirds of the risk, of hedge funds, resulting in comparable Sharpe ratios, on average.

However, one of the main drivers of the return differential is likely the illiquidity premium; hedge funds can take advantage of less-liquid investment opportunities over time as they are not subject to daily pricing and daily asset flows. Furthermore, hedge fund vehicles have greater flexibility to increase leverage when volatility is low. Meanwhile, single-strategy alternative mutual fund manag-

ers should have an advantage over the multialternative managers, particularly as it pertains to the multi-sub-advisor model: in general, the fees associated with the multi-sub-advisor model will signifi-cantly exceed those of the single-strategy provider. However, manager and strategy concentration risk will increase when investing in single-strategy alternative mutual fund vehicles. Ultimately, this risk is smaller relative to similar concerns on the hedge fund side, given that the rules and regula-tions governing mutual funds provide a much higher level of protection versus hedge fund and other alternative vehicles. While the SEC is increasing its oversight of hedge funds, the ’40 Act mutual fund universe is subject to strict rules and regulations on liquidity, fees, transparency and reporting/disclosures, which now extend to managers running alternative mutual fund products.

Portfolio Appropriateness

While it remains to be seen how differently alternative mutual funds behave relative to hedge funds, they should offer some similar benefits to an investor’s portfolio. Over time, alternative strategies have proven to complement investments held in traditional portfolios, offering the opportunity to improve a portfolio’s return potential without significantly increasing risk. These strategies have historically exhibited low to moderate correlation to fixed income markets and imperfect correlation to equity markets, and therefore have served to enhance a portfolio’s diversification benefits, especially in down markets. Through the emergence of alternative mutual funds, retail investors may now benefit from the aforementioned characteristics in their respective portfolios. Similar to hedge fund investors, retail investors have the option to gain exposure either directly or indirectly through a multialterna-tive vehicle. Much the way a fund of hedge funds provides a qualified investor access to an array of managers and strategies, multialternative vehicles will allow an investor to gain broad exposure to the alternatives market.

It is also expected that alternative mutual funds will become more widely used by individuals participating in defined contribution plans. This is relatively uncharted water for such strategies, but over time, as more established hedge fund managers launch liquid vehicles or participate in multialternative offerings, defined contribution plans may become more comfortable adding such vehicles to their plat-forms. Participating individuals will then be able to reap the benefits of alternative strategies in their retirement accounts.

“ In general, expectations are for hedge fund strategies to produce greater returns, with greater risk, as they are less constrained in their use of leverage and illiquid investments.”

“ It is also expected that alternative mutual funds will become more widely used by individuals participating in defined contribution plans.”


13

Institutional investors can also use alternative mutual funds for various purposes. Most institutions qualify for access to hedge funds, as they have the ability to lock up capital for longer periods. As such, they are able to tap the liquidity premium that a more illiquid vehicle should offer. However, they may seek to use the more-liquid versions of these strategies to hold cash and/or bridge investments. When redeeming from hedge fund investments, the cash is typically received after the first of the month. This cash cannot be deployed to a different hedge fund vehicle that has monthly subscrip-tions that typically require cash to be wired prior to the first of the month. Institutions now have the option to invest this capital in alternative mutual fund vehicles, which offer daily subscriptions and redemptions. Institutional investors also expect to receive an attractive illiquidity premium for locking up their capital in less-liquid alternative strategies. If, over time, alternative mutual funds perform in a fashion that makes this illiquidity premium less attractive, it would be reasonable to consider alterna-tive mutual funds for the same mandates as hedge fund strategies.

ConclusionAlternative mutual funds have been, and likely will continue to be, an area of significant growth, in terms of both assets as well as the number of vehicles coming to the market. The past few years have seen an annual asset growth of more than 30 percent, which is expected to continue for some time as investors embrace these products. The main drivers of growth will likely include demand from investors, Registered Invest-ment Advisors and private wealth managers, as well as institutions, particularly those subject to regulatory capital requirements, and the defined contribution marketplace. Furthermore, investment managers have started to embrace the concept of liquid alternatives, and continue to launch new funds, which will contribute to growth of the industry over time.

The major differences between alternative mutual funds and hedge funds are summarized in Table 9 below.

Segal Rogerscasey Canada sees the applicability and attractiveness of these strategies primarily for retail and high-net-worth individuals, and perhaps for select institutions that may elect to use these investment options to take advantage of the liquidity and/or transparency and more modest invest-ment minimums they offer. However, medium and large institutional investors should carefully consider their relative strategy-implementation limitations as potential performance headwinds. In our view, hedge funds should outperform alternative mutual funds due to access to less-liquid opportunities and application of higher risk-taking without leverage constraints.

Table 9: Summary of the Major Differences between Alternative Mutual Funds and Hedge Funds

Alternative Mutual Funds Hedge Funds

Investor Qualifications Low High

Liquidity High Medium

Transparency High Medium

Leverage Low Medium to High

Fees Medium High

Investment Minimum Low High

“ Investment managers have started to embrace the concept of liquid alternatives, and continue to launch new funds, which will contribute to growth of the industry over time.”


Segal Rogerscasey Canada provides consulting advice on asset allocation, investment strat-egy, manager searches, performance measurement and related issues. The information and opinions herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. Investment Focus and the data and analysis herein is intended for general education only and not as investment advice. It is not intended for use as a basis for investment decisions, nor should it be construed as advice designed to meet the needs of any particular investor. Please contact Segal Roger-scasey Canada or another qualified investment professional for advice regarding the evalu-ation of any specific information, opinion, advice or other content. Of course, on all matters involving legal interpretations and regulatory issues, investors should consult legal counsel. Copyright © 2014 by The Segal Group, Inc. All rights reserved.

We view alternative mutual funds as a differentiated investment option relative to hedge funds. Both approaches have their advan-tages and issues; however, for specific portfolio management reasons, they may be used alongside one another and not neces-sarily considered mutually exclusive. Institutional investors should

continue building their core hedge fund portfolios; however, should they need to invest excess cash or seek a short-term investment while rebalancing, alternative mutual funds can fulfill these roles. That said, we view the primary audience for alternative mutual funds to be individuals and small institutions, which can truly benefit from the “ease of use” and the lack of investor qualifications associated with these strategies, while achieving portfolio diversification benefits similar to hedge funds.

Much like hedge funds, alternative mutual funds are offered in many shapes and sizes. Teams managing these strategies will possess different levels of qualification, strategies will be executed in different ways, and fees can vary significantly. Ultimately, manager selection will remain just as important in the alternative mutual fund space as it is in the hedge fund space. Proper due diligence will be required to source best-in-class managers. n

“ We view alternative mutual funds as a differentiated investment option relative to hedge funds.”

Questions? Contact Us.

For more information about liquid alternative strategies, contact your Segal Rogerscasey Canada consultant or one of the following investment professionals:

Segal Rogerscasey Canada provides investment solutions and consulting advice to corporations, plan sponsors and retail clients across Canada. For more information about the firm, visit http://www.segalrc.com/canada/.

To receive issues of Investment Focus and other Segal Rogerscasey Canada publications as soon as they are available online, register your e-mail address via http://www.segalrc.com/register/.

Segal Rogerscasey Canada is a member of The Segal Group (www.segalgroup.net), which is celebrating its 75th anniversary this year, and the Global Investment Research Alliance (http://www.gir-alliance.com/).

Kathleen Pabla 416.642.7791 [email protected]

Charles Colfer 203.621.3636 [email protected]

Investment Focus - Segal · PDF fileconsultant or one of the following ... To receive issues...

Documents

Transcript of Investment Focus - Segal · PDF fileconsultant or one of the following ... To receive issues...