The explosion of alternative-strategy mutual funds and exchange-traded funds has been a boon to advisors whose clients are still leery about stocks and increasingly disappointed by bonds. But, while assets are rising and new products continue to roll out, some holdout investors and advisors still ask, "What the heck are 'alternative funds' anyway?" and furthermore, "What will they do for me?"

The common notion is that alternative investments (alts) are products intended to produce returns that are uncorrelated (or only mildly correlated) with traditional portfolios of stocks and bonds. For years, many of the techniques and securities that were used to produce these uncorrelated returns were found only within hedge funds, pensions and private portfolios for clients who either didn't need ready access to their money or whose cash flows were predictable and stable. However, well-publicized success by certain Ivy League endowment managers prompted advisors to demand alts from fund manufacturers, and the industry responded with lots of new products and services to help advisors position alts in their clients' portfolios.

In Lipper's classification system for mutual funds and ETFs, we monitor 17 groups that are often considered "alternative" in nature. Within those classifications, there are 1,002 funds with $750 billion in assets as of June 30, 2013. (Although at Lipper we do not consider long-only products—such as commodities or real estate—to be alternative investments, we include them here for illustrative purposes.)

Avoiding Correlation
One of the first advantages that alt fund manufacturers claim is portfolio diversification. The idea is that within a traditional mix of stock and bond funds, an alt fund will behave differently. However, recent history shows that—at a high level—few alternative classifications come close to providing the perfect (zero) correlation advisors seek.

The strategies with the best diversification benefit against the S&P 500 (and a possible better fit for an investor with a heavy equity exposure) are Commodities Specialty funds (with a -0.14 correlation) and Managed Futures funds (0.12). Unfortunately for most long-term investors, the products found in Lipper's Commodities Specialty group are the leveraged-long or leveraged-short ones, which are inappropriate for investors who don't rebalance daily.

Managed Futures funds, on the other hand, do a very nice job diversifying an equity-heavy portfolio, with one small caveat—just six products in this group of 27 have at least three years of performance. And while attributing a diversification benefit across all of them may seem too generous, so far it's been accurate. Correlations within this group versus the S&P 500 range from minus 0.12 to positive 0.18. Dedicated Short-Bias funds, on the other hand, have a strong negative correlation to the S&P 500, which is good for hedging purposes but not for diversification—two distinct concepts.

Bond investors are more likely to benefit from alt fund diversification. Correlations versus the Barclays Capital U.S. Aggregate Bond Index—the popular fixed income benchmark—are generally closer to zero among alt funds than they are against the S&P 500. Products in Lipper's Commodities Agriculture classification provide the best diversification benefit, with a correlation of zero on average (albeit some funds are a little above and some are a little below).

If we look beyond the Commodities Specialty funds, we find that Absolute Return funds (0.03), Currency funds (0.06) and all flavors of Real Estate funds (0.03 to 0.08) all provide excellent diversification potential as well. On the outside, Precious Metals Equity funds (the ones that buy gold-mining stocks) and Commodities Precious Metals funds (the ones that buy gold futures) also do quite well, showing correlations of 0.10 and 0.12 on average, respectively.

Performance and Volatility
But diversification alone won't be enough to help clients reach their goals. When it comes to performance, particular strategies stand out.

Over the past three years, a rising equity market has been most kind to leveraged products. Both the Equity Leverage and Extended Large-Cap Core (mostly 130/30 funds) groups produced stellar returns. However, the domestic Real Estate funds group was not far behind, and funds within that group typically employ no leverage at all.

After the three real estate groups, performance drops sharply, and several alt groups in the commodities space have losses over the past three-year period. With an annualized return of just 1.15% on average, it's clear that making a case for alts must go beyond their performance.

So, let's consider their volatility as well. At the high end, leveraged products delivered exceptional amounts of volatility (as one would expect), and Precious Metals Equity funds suffered wild performance swings. Lower volatility funds are found in Long/Short Equity (with an annualized standard deviation of 8.97 on average), Currency funds (8.56), Managed Futures funds (8.31) and Absolute Return funds (5.23). For comparison, over the past three years the S&P 500 had a three-year annualized standard deviation of 13.15, and the Barclays Capital U.S. Aggregate Bond Index delivered a standard deviation of 2.78.

In the aggregate, what we find is that if the alts were students, we would have a class of underachievers. However, there are a few bright spots—Absolute Return and most of the Real Estate products received a B, which indicates that even their middle-of-the-road peers stand a good chance of proving their worth.

When selecting funds, look for those with a low correlation to the S&P 500, as Absolute Return funds typically have low correlations to the bond market already. It's highly unlikely you'll find real estate strategies with near-zero correlations to the equity market and those that are below 0.7 are often investing in something overly narrow, like residential mortgages, which could give investors a nasty surprise with their volatility.

Other classifications come close to making the grade but need a sharper eye on them. Managed Futures are excellent diversifiers with low volatility, but only a few names in this group have positive performance over the past few years. And Commodities General funds (which, as the name implies, are diversified within their portfolio of commodities) are your best bet for mitigating volatility and achieving better diversification; although they've gotten crushed recently, they might right themselves over a longer time horizon.

Choose Wisely
And that's a good final point to consider—we've looked back at alts over the past three years, and in that time manufacturers have flooded the market with new products. While it's impossible to know which products will outperform going forward, the data we have suggests that only a few of these strategies will do a good job of satisfying the three requirements we set up for them—portfolio diversification, good performance and low volatility. Even a modestly successful product within them can enable planners to build portfolios with better risk-adjusted returns.

Jeff Tjornehoj is head of Lipper Americas Research, focusing on the United States
and Canada. He is a regular contributor to Lipper's Fund Flows and Closed-End Reports.

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