In light of a recent downturn in bonds caused by a perception of the Fed’s upcoming actions, a Barron’s blog post and a Morningstar article explore alternative investments with “bond-like” returns. However, it turns out that these alternatives behave mostly like stocks with poor return-to-risk characteristics, and thus do not provide diversification to a broader portfolio.
To illustrate, here are correlations to stocks and Sharpe Ratios derived from Morningstar’s statistics for mutual funds and ETFs mentioned in the post and article:
|S&P 500®||SPX||Stock Index||1.00||13.56||1.00||1.32|
|IQ Merger Arbitrage ETF||MNA||Market Neutral||0.26||5.08||0.69||0.37|
|Robeco Boston Partners L/S Rsrch||BPRRX||Long/Short||N/A||N/A||N/A||N/A|
|IQ Alpha Hedge Strategy||IQHOX||Multialternative||0.31||6.54||0.64||0.36|
These three-year statistics indicate a high positive correlation to stocks coupled with sub-par risk-adjusted returns. This observation is corroborated by a new study from the Leuthold Group cited in The Wall Street Journal article that states:
“From 1994 through May, it found that hedge-fund correlations have slowly been inching up to 0.75, almost 36% higher than earlier levels. Since a measure of 1.00 represents lock-step movements, hedge fund returns are generally following the tendencies of stocks about three-quarters of the time… Funds with correlations to stocks of 0.6 or less are prized by investors since they can significantly reduce portfolio volatility and limit risks over full-market cycles.”
In the past month or so, these alternative funds held their value well relative to bond investments. This is supported by their negative or low positive three-year correlations to iShares Core Total U.S. Bond Market ETF (AGG), as estimated by Alpholio™:
|IQ Merger Arbitrage ETF||MNA||-0.30|
|IQ Alpha Hedge Strategy||IQHOX||0.27|
For reference, the correlation of SPDR® S&P 500® ETF (SPY) to AGG over the same period is -0.33. Therefore, these alternatives do not provide a significant amount of diversification to a balanced equity-and-bond portfolio, but could be marginally helpful if the portfolio contains only bonds. However, even in the latter case they could be a drag on the risk-adjusted performance of the portfolio: at 1.31, the Sharpe Ratio of SPY is higher than that of any of the above funds.