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:

Fund Ticker Category Beta StDev Correlation Sharpe Ratio
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
Merger MERFX Market Neutral 0.12 2.63 0.62 1.07
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™:

Fund Ticker Correlation
IQ Merger Arbitrage ETF MNA -0.30
Merger MERFX -0.24
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.

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