Are alternative mutual funds attractive for retail investors as hedge fund surrogates? In their June 2014 paper entitled “Performance of Alternative Mutual Funds: The Average Investors Hedge Fund”, Srinidhi Kanuri and Robert McLeod analyze the performance of alternative mutual funds that employ strategies similar to those of hedge funds and seek returns uncorrelated with the equity market. These funds can sell short and use leverage, derivatives, options and swaps to shape and enhance returns. However, they must offer daily liquidity, cover short positions, limit borrowing to a third of assets and limit illiquid investments to 15% of assets. The authors consider nine categories of alternative mutual funds, ranging in population from just three inverse commodity funds to 109 long-short equity funds. They apply both a four-factor (equity market, size, book-to-market, momentum) mutual fund model and a seven-factor (equity market, size, bond market, credit spread, bond trend, currency trend, commodity trend) hedge fund model to measure alternative mutual fund alpha. They aggregate across all funds and within categories based on equal weight. Using monthly data for 256 surviving and 62 dead alternative mutual funds during January 1998 through December 2011, they find that:
- Most alternative mutual funds have annual expense ratios of 2% or more.
- Based on both factor models, alternative mutual funds have significantly negative net alphas.
- Across all 318 funds, average annualized net alpha for both mutual fund and hedge fund models is -3.1%.
- The most successful category for both models is Managed Futures (only 13 funds), with an annualized net alpha of 1.4% for the mutual fund model and 4.6% for the hedge fund model.
- Based on both factor models, alternative mutual funds do not outperform during equity bear markets.
- Most alternative mutual funds (even the Bear Market category) have negative net alphas when market returns are negative.
- Less than half the funds have positive net alphas when market returns are positive.
- The Managed Futures category has mostly positive net alphas in both environments.
- The performance of alternative mutual funds (even the Bear Market category) was very poor during the financial crisis (October 2007 through March 2009). Across all 318 funds, annualized net alpha is of -7.5% for the mutual fund model and -7.0% for the hedge fund model.
- In aggregate, alternative mutual fund managers exhibit neither successful market timing nor exceptional security selection.
- None of the alternative mutual fund categories exhibit performance persistence.
- Assets under management, expenses and fund age all relate negatively to alternative mutual fund performance.
In summary, evidence indicates that most alternative mutual funds underperform relevant models.
Cautions regarding findings include:
- The sample period is not long for analysis of annualized performance.
- The numbers of funds in some categories are very small.
See also “The Timing Value of John Hussman’s Market Climate Assessments”.
Frequently Asked Questions
What are alternative mutual funds and how do they differ from regular mutual funds?
Alternative mutual funds are retail funds that use hedge-fund-like strategies and seek returns uncorrelated with the equity market. They can sell short and use leverage, derivatives, options and swaps, but must offer daily liquidity, cover short positions, limit borrowing to a third of assets and limit illiquid investments to 15% of assets. The study examined nine categories, ranging from three inverse commodity funds to 109 long-short equity funds.
Do alternative mutual funds outperform after fees?
Alternative mutual funds do not outperform after fees; across 318 funds, average annualized net alpha is -3.1% under both a four-factor mutual fund model and a seven-factor hedge fund model (January 1998 to December 2011). Managed Futures was the best category, with annualized net alpha of 1.4% and 4.6% in the two models, but it contains only 13 funds. Most funds have expense ratios of 2% or more.
How is the alpha of alternative mutual funds measured?
Alternative mutual fund alpha is measured with two factor models: a four-factor mutual fund model (equity market, size, book-to-market, momentum) and a seven-factor hedge fund model (equity market, size, bond market, credit spread, bond trend, currency trend, commodity trend). The authors used monthly data for 256 surviving and 62 dead funds from January 1998 through December 2011. Results are aggregated across all funds and within nine categories using equal weighting.
Do alternative mutual funds protect investors during bear markets and financial crises?
Alternative mutual funds do not outperform during equity bear markets under either factor model, and most, even the Bear Market category, have negative net alphas when market returns are negative. During the financial crisis (October 2007 through March 2009), annualized net alpha across all 318 funds was -7.5% in the mutual fund model and -7.0% in the hedge fund model. Managed Futures was the exception, with mostly positive net alphas in both up and down markets.
What are the limitations of research on alternative mutual fund performance?
The research on alternative mutual fund performance has two main cautions: the January 1998 to December 2011 sample period is not long for analyzing annualized performance, and some categories contain very few funds (for example, three inverse commodity funds and 13 Managed Futures funds). Category-level results are therefore less reliable than the aggregate findings. The study also found no performance persistence in any category, and that assets under management, expenses and fund age all relate negatively to performance.