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By David Lafferty

In the four years since the financial crisis and market meltdown, investors around the globe have increasingly turned to alternative investments. Unfortunately, it's become quite fashionable to denigrate the performance of alternatives by noting that many of these strategies and products have "lagged the S&P 500®" or some similar equity benchmark. These comparisons are often made by investors, equity managers (no surprise there) or the financial media.

As with many trendy topics, there's been a tendency to overhype the new thing (growing interest in alternatives) while simultaneously tearing it down (alts aren't all they're cracked up to be). This adds drama to the story and makes for good reading.

To be sure, there are plenty of alternative investment strategies that invest mostly, if not exclusively, in equities and equity-related assets. Furthermore, some of these strategies take on full market exposure (i.e., beta = 1.00) or more, such as hedge funds that invest in emerging markets or private equity. However, the majority of alternative strategies have a different investment objective: to pursue high risk-adjusted returns (i.e. high Sharpe ratios).

Lower volatility, lower beta

The table below highlights the relative risk measures for the five major alternative categories in Morningstar's U.S. mutual fund universe over the past five years in relation to the S&P 500. Based on this data, it's clear that on average, most alternative strategies (as measured here in the liquid '40 Act space) take on significantly less risk than the stock market.

Relative risk measures between October 1, 2007 and September 30, 2012

Index/Morningstar Category

Volatility (5-yr STD)

Volatility % of the S&P 500

Beta vs. S&P 500 (5-Yr.)

S&P 500 Index

19.13%

100%

1.00

Long/Short Equity

12.58%

66%

0.41

Currency

11.65%

61%

0.19

Multialternative

10.72%

56%

0.33

Managed Futures

9.38%

49%

0.12

Market Neutral

5.37%

28%

0.04

Source: Morningstar, Natixis ISG

So here's the question: Is it appropriate to measure a strategy's success against a benchmark that typically takes on far more risk? If you believe there is a relationship between risk and long-term returns (Finance 101), it's safe to conclude that it would be extremely difficult to outperform stocks over the long run with say, half the risk.

The exception would be when the long run includes a steep bear market - which it often does. The fact that there have been two such periods within the last 12 years has contributed to the ascendency of alternatives.

Crying foul

There's good reason to cry foul over this benchmarking issue. When viewed from the standpoint of risk-adjusted returns, an alternative manager delivering two-thirds of the return of the S&P 500 at one-half the volatility should be considered excellent, in spite of "underperforming" the market.

Excessive focus on comparative returns obscures the real reason to include diversified exposure to alternatives in a portfolio, which is to mitigate risk. Yes, there are some alternative strategies that can take on significant market risk and help enhance returns, but this is not typically the case. As their name implies, hedge funds, historically the preferred vehicle for alternatives, are supposed to be "hedged."

Comparing alternative strategies and products to indexes that systematically take on substantially more risk (like the S&P 500 or MSCI World) misses the point. For investors concerned about building meaningfully diversified portfolios, we believe the term "risk-managed" should always precede the word "alternatives." You may want to keep that in mind next time you read about alternatives lagging the market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Diversification through the use of alternative investments strategies may result in a profit or a loss and can underperform during periods of strong market performance.

The opinions expressed in this reprint are those of the author(s) and interviewee(s). This reprint may not be distributed, published, or reproduced, in whole or in part, without the prior approval of Natixis Global Asset Management.

Source: Benchmark Comparisons Miss The Point