The alternatives mutual fund sector has closely resembled the Wild West over the past four years.
The fledgling asset class has given rise to a number of new strategies, not to mention new asset management firms, that advisers are left having to sift through.
Morningstar Inc. recently took a step toward making it easier to pick the best funds in the alternatives category by issuing forward-looking ratings of the funds for the first time.
As of June, the research firm was rating 40 mutual funds, covering nearly 75% of the assets in the alternatives category.
Morningstar's traditional star ratings system isn't a good fit for alternatives funds, because it re-quires at least a three-year track record, and the majority of alternatives funds are still too young to qualify.
The new forward-looking ratings are based on five “pillars”: performance, investment pro-cess, management team, parent company and the cost of owning the fund.
Funds that score high enough to rank as a recommended fund by Morningstar are rated gold, silver or bronze. Funds that don't are rated either neutral or negative.
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Only one alternatives fund, the TFS Market Neutral Fund (TFSMX), scored a gold in the initial round of ratings. It's one of the few alternatives funds with a long-term track record. Its five-year annualized returns of nearly 4% outpaced the S&P 500 by more than 400 basis points in spite of its high expense ratio of 2.47%.
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AQR Capital Management LLC was the only firm to score Morningstar recommendations for multiple funds. The AQR Diversified Arbitrage Fund (ADAIX) and the AQR Managed Futures Fund Ticker:(AQMIX) both received silver ratings.
Some firms that received top ratings are hardly household names: Water Island Capital LLC, Westchester Capital Management LLC and Summit Portfolio Advisors LLC.
More than half of the 40 funds rated by Morningstar garnered a neutral or negative rating.
Morningstar expects to expand its forward-looking ratings to more than 100 alternatives funds over the next year.
While the new ratings will certainly help advisers in their due diligence, there's still a lot of legwork left up to the adviser.
For one, given the esoteric nature of the strategies, advisers have to figure out the best way to monitor a fund after it's been chosen. Unlike stocks and bonds, there are few widely followed and simply constructed indexes against which to benchmark alternatives.
There are several indexes made up of hedge fund returns, but given the Investment Company Act of 1940's restrictions on mutual funds, it's not really an apples-to-apples comparison.
Scott Curtis, president of Raymond James Financial Services Inc., said he's particularly wary of firms that tout the track record of hedge funds but only recently have launched "40 Act versions.
“The strategy isn't an exact copy — maybe a reasonable facsimile,” he said. “The "40 Act fund may give them a broader reach, but in some cases, advisers don't really know what's being used to make the soup.”
Raymond James utilizes a six-person research team that is focused on alternatives to handle the due diligence.
Advisers that don't have Raymond James' resources are mainly left benchmarking alternatives mutual funds against their peers. Given the differences within certain categories, such as managed futures, that could be less than ideal.
Gary Vawter, founder of Vawter Financial Ltd., has taken a unique approach to keeping an eye on his alternatives funds. He relies on sales calls from other alternatives funds to poke holes in his current holdings.
“We get dozens of sales calls every day,” Mr. Vawter said. “They'll immediately get into why their fund is better.”
He then uses that information to help form his future decisions.
“Competition is a very good thing,” Mr. Vawter said.
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