Benchmarking alternatives that fit in clients’ portfolios can be tricky. But for some alternatives, once you consider the benchmark, the more difficult part is justifying the investment's place in the portfolio.
Here are some alternatives where the logical benchmark can lead to the conclusion that they have no role in a portfolio.
MARKET NEUTRAL FUNDS
Market neutral funds try to match short and long positions to achieve a beta near zero. Morningstar’s criteria is that the beta exposure be between -0.3 and +0.3. The Capital Asset Pricing model shows that a zero beta fund should be expected to earn the risk free rate of a short-term Treasury bill, which is currently close to zero. Since an investment with an expected return of cash with far more volatility would be hard to argue was appropriate for a client, one should think twice before putting a client in such a fund. If you do believe they can generate a net alpha, then define that expected annual alpha.
Managed futures are easy to benchmark. The expected return before fees is zero as not a penny has ever been made, in the aggregate, in the futures or options market. They are a zero sum game before costs and Morningstar shows the five year returns averaging a -2.47% annually.
Explaining this to a client quickly eliminates this alternative. The futures markets are great for businesses to manage risk but fail the pure investment test.
Currency funds invest in short-term money markets of foreign currency or in forward contracts or swaps. As previously discussed, short-term yields are near zero and the forward contracts are the same zero sum game. Thus, it’s not surprising that three year returns are negative and five year returns are a modest 1.98% annually, according to Morningstar.
BEAR MARKET FUNDS
Finally, bear market and levered bear market funds can give downside protection and the benchmark is obvious in that it should give the downside protection bargained for. But the role of the bear market fund is somewhat illogical if you also have the client invested long in the market.
How do you explain benchmarking large cap stocks against the total return of the S&P 500 and the levered short S&P 500 fund on three times the loss of the same index? That’s like betting on both teams in a Super Bowl game. It’s not a smart bet, yet I see it too many times.
If you do use these alternative funds for clients, it’s critical to come up with an alternative benchmark. It would not be appropriate to benchmark against the category if the category is flawed.
For example, the Durham Alternative Strategy Fund (DCASX) lost only 0.24% annually over the past five years compared to a managed futures category average loss of 2.47%, but it may be hard to argue to the client that they should be happy with this loss. A better benchmark would be a simple weighting of low cost stock and bond funds giving a similar standard deviation to the fund being benchmarked.
And remember, the benchmarks I’m suggesting are extremely subjective. The main goal is to help advisors think about the composition of the alternative assets and determine their role in clients’ portfolios. The more difficult the benchmark, the less likely that it belongs in a portfolio. If you can’t explain the fund to your client, perhaps you should rethink using it.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.