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”.
