Alternative investments are an extremely heterogeneous asset class. Some market environments aremore favourable to certain alternative investment styles than others.

For example, managed-futures strategies fared very well in 2013, when clear trends in equities and fixed income emerged, but they suffered significant drawdowns in the far choppier markets of 2016.

It can be difficult timing and tilting allocations within this Morningstar category, so diversified alternatives are a possible solution for outsourcing this decision-making. Therefore, for investors seeking to capture a broad range of alternative exposures, and thus smooth the return profile of their alternative allocation, a strong case can be made for investing in a diversified alternative strategy.

Fund of funds

This has been the classic way to gain access to a multitude of hedge-fund/alternative investment strategies at once. In this structure the manager invests in a portfolio of other single-strategy hedge funds.

Some of the advantages include ease of access to various hedge fund / alternative strategies; access to alternative strategies not readily available to retail investors; and they can be highly diversified.

This approach also has some room for the manager to generate alpha and respond to market conditions. For example, if the manager has skill in picking sub-managers, they may earn returns above the average manager in that space. Another way to generate alpha is to attempt to identify which strategies will outperform in a given market environment, and overweight that strategy.

Disadvantages

On the negative side, fees can be very high due to the layering of management fees--which can add up quickly and diminish your potential returns.

Over-diversification may also detract from overall returns--compounded by the above problem of high fees.

The propensity for managers to try and time alternative strategies may also create problems, along with low correlations to equities.

We think the cons outweigh the pros in this space, and don't recommend any strategies of this type currently.

Quantitative alternative/hedge fund beta strategies

Advantages of these strategies, which use quantitative models to replicate hedge-fund strategies or access alternative betas, include their repeatability and consistency; their ability to be tailored toward certain outcomes and less requirement for daily decision-making.

Disadvantages include high fees--though less so than fund of funds--and little opportunity for alpha generation in comparison to active managers.

We are quite amenable to this approach, as indicated by our ratings in this space. We are particularly enthused about the careful risk-management employed, as well as the repeatability of the process, both of which we believe are especially essential to a successful outcome for alternative strategies.

Global macro strategies

These aren't new to the Australian market, but they have become more popular recently, and we have seen a bevy of both systematic and discretionary macro offerings coming to market in the past few years.

These strategies tend to have explicit cash-plus targets, stringent volatility limits, and an explicit aim to limit downside participation.

The two strategies we cover currently are both discretionary global macro, meaning they focus on fundamental analysis of macro-economic conditions. Portfolio managers weigh up the pros and cons of varying positions in order to reach their investment objectives. The investment universe is extremely broad, covering almost any liquid asset class.

Advantages of this approach include lower fees than other alternative strategies, and an explicit focus on downside protection.

Disadvantages are their high complexity, which emphasises the importance of manager ability; potential conflicts between downside protection and return targets; and the requirement for vast informational flows.

Overall, we believe this type investment strategy has merit, particularly given the explicit aim to limit downside, and generally lower fees for an alternative investment. But careful selection of the right manager remains essential given their complexities.

What to look for

We think your first port of call when looking to invest in the diversified alternatives space should be our qualitative fund reports. As you’d expect, we recommend you focus your efforts on Morningstar Medallist funds.

However, when doing your own research, we think looking at a few quantitative metrics can also be helpful to assess the past performance of a strategy and observe whether it has performed in line with its intended objectives.

The biggest challenge to this remains the short performance histories of these funds, but this is becoming less of an issue. We’d suggest looking at quantitative metrics over at least five years, and the longer the better, especially if you can observe performance of these strategies over an equity bear market.

This is a complex space, with many approaches to similar objectives. The results from these strategies have been mixed, and few have genuinely been able to provide sufficient portfolio diversification to justify their often-elevated fees.

Still, there are certain strategies we think are worthy of consideration, and we intend for this article to both clarify the investable universe and provide a guide to reading our reports and evaluating these funds quantitatively.

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Elliot Lucas is an analyst in Morningstar Australia's manager research team.

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