In the years since UCITS III, the number of funds adopting sophisticated strategies has grown dramatically. In the past, most of these strategies have been limited to hedge funds and rarely created as Unit Trusts or Open End Investment Companies (OEICs) for the broader individual investor. The changes embodied in the UCITS III directive, allowing for "sophisticated" UCITS, the relative success of alternative strategies throughout the global financial crisis, as well as the liquidity and regulatory protections of regulated funds, have created the perfect storm for these strategies to flourish in the regulated fund marketplace.
Up until now, Morningstar has primarily grouped these funds into three categories: EUR Absolute Return; Non-Euro Absolute Return; and Long/Short. Unlike most Morningstar Categories, the two absolute return categories have been based upon a prospectus objective, rather than the underlying investment portfolio or strategy implementation. The common feature of Absolute Return funds is the choice of a named absolute (positive) benchmark, such as inflation plus 4% annually, rather than a relative benchmark, such as the FTSE All Share Index. The Long/Short category has been more sensitive to strategy implementation, segregating funds with standard practices of assuming negative exposures to securities into a single category.
Morningstar generally uses underlying investment portfolios as its primary determinant for category selection. The secondary criteria have been strategy implementation techniques. Our new categories for alternative strategy funds in Europe follow the standard Morningstar processes. The three aforementioned categories are being re-assigned to eighteen portfolio and strategy based peer groupings. Notably, we've removed consideration of the "absolute return" objective from our new category framework.
Our removal of these categories is not intended to demagogue funds with a stated return objective. In many cases these stated positive return goals are quite useful in evaluating the success of these funds, but a return objective does little to inform investors of how funds intend to execute portfolio management. The new categories should provide guidance for investors in the evolving market for alternative strategy mutual funds.
The Categories
The Long/Short category has been sub-divided into six categories, one debt, and five regional based equity categories. In hedge fund jargon, these are considered directional.
Funds within the Alt-Long/Short Debt category engage in the purchase or sale of Credit Default Swaps, and other financial derivatives to hedge a portion of market exposure. One of the larger funds in this new category is the Threadneedle Absolute Return Bond fund, this fund has the flexibility to purchase CDS, shorting credit risk, trade interest rate futures, and other fixed interest trading strategies that are not common in long-only debt funds.
The five directional equity categories look further into portfolio holdings to identify regional focuses in addition to the underlying asset class of equities. Funds with focuses on greater Europe, the United Kingdom, the United States, and Emerging Markets funds without a specific regional focus are within our Alt-Long/Short Equity - Global category. These funds assume material short exposures, through direct short sales of equities, selling equity index futures, and entering into contracts for difference. One new entrant into this space is the Theorema European Equity Long-Short fund, which falls into the Alt-Long/Short - Europe category.
The exception to this definition are 130/30 funds. The purpose of the short position in a long/short fund is to reduce Beta and correlations to the market. This differs in 130/30 funds, which do not use the short holdings to reduce market exposure.
The next group of new categories attempts to fully mitigate the market as a source of returns. In academia these strategies go by various names, arbitrage, relative value, and market neutral. By fully hedging the market exposure of the portfolio these strategies seek returns that are solely alpha, independent of the movement of the stock or bond markets. We’ve launched three categories to create peer groups for these funds: Alt - Market Neutral - Equity, Alt - Debt Arbitrage, and Alt - Diversified Arbitrage. As their names imply each category should isolate relative value strategies based upon the exposures within the underlying portfolios. Market Neutral - Equity strategies invest primarily in equities and equity linked derivatives. JPM Highbridge Statistical Market Neutral fund has been operating an equity market neutral strategy in UCITS form since 2007, but this strategy is also available in the United States as a mutual fund and as a fully unconstrained hedge fund in the Cayman Islands. Similarly, funds within the Debt Arbitrage strategy invest primarily in debt instruments and related derivatives. Diversified Arbitrage funds are not primarily invested in either of the other two arbitrage strategies, these funds invest in a mix of asset classes while still hedging substantially all market exposures.
Each of the first nine categories discussed are first based upon investment strategy before examining the asset class in which the fund invests. The next grouping switches that around, first looking at the asset classes in which underlying portfolios invest before looking at the strategy. Funds in this grouping make their investments primarily through derivatives.
The Alt-Systematic Futures category includes funds which take a technical approach to investing in the futures markets. Most of these funds use momentum-based strategies relying little on manager discretion. Man AHL Diversity is one fund using this systematic technique in developing its positions. Positions for these funds are generally considered directional.
On the opposite side of this spectrum are the Global Macro funds. Managers of these funds tend to rotate sectors and asset classes of both long and short positions based upon fundamental research and macro-economic forecasts; momentum and technical signals rarely come into play. Funds following this strategy take both directional and relative value positions.
The final two categories within this grouping are Currency and Volatility. Currency funds earn returns based upon foreign exchange markets. These investments can include currency pairs; directional positions in a single currency as well as other trading strategies tied to movements in exchange rates. The Absolute Insight Currency fund is one large example of a fund focused on foreign exchange trading.
Volatility strategies include both volatility arbitrage and option writing strategies, among others. Price changes in derivatives due to movements in implied and expected volatility are the main return driver for these funds.
The remaining alternative strategy categories can be considered multi-process in nature while investing in multiple asset classes. Funds within the event driven category engage in both relative value and directional trades associated with corporate events including: bankruptcies and reorganisations, mergers and acquisitions, and changes in corporate strategy.
Multistrategy funds allocate across a range of alternative strategies through a single management team. These funds primarily differ from global macro based upon strategy execution. Multistrategy funds generally use fundamental security selection within each of the underlying strategies, while macro funds focus on picking the correct asset class.
The last three multi-process categories are Alt-Fund of Funds - Equity, Alt - Fund of Funds - Multistrategy, and Alt - Fund of Funds - Other. Typically, Morningstar has not isolated fund of funds from single manager funds. We've changed our position for alternatives as few would meet the criteria for any category other than Alt-Multistrategy. UCITS Funds of Hedge Funds resemble hedge fund of funds more than fund of funds using traditional strategies. There is a body of academic literature demonstrating differences between fund of funds and multistrategy hedge funds. As such we've opted to follow the practices of the hedge fund industry and isolate these funds for peer group analysis. Funds within the Alt - Fund of Funds - Equity category generally are diversified across market neutral and long/short underlying funds. The Alt - Fund of Funds - Other captures funds with a single asset class focus such as funds diversified between global macro and systematic futures strategies, and the Alt - Fund of Fund Multistrategy category includes funds of funds diversified across all of the above alternative fund strategies without a specific focus.
As the market for alternative investments continues to converge we expect more and more funds to launch populating these categories. Many funds are regulated versions of hedge funds available to institutions and qualified investors, our categories for hedge funds and European open-end funds are based upon the same structure. We hope these categories help navigate through the wide variety of asset classes and trading strategies now widely available to all investors.
The category changes came into effect on Morningstar Web sites on April 30, 2011.
