Diversified Alternatives Index

Transcription

1 The Morningstar October 2014 SM Diversified Alternatives Index For Financial Professional Use Only 1 5 Learn More indexes@morningstar.com Contents Executive Summary The Morningstar Diversified Alternatives Index 11 Conclusion 1 Appendix Executive Summary Alternative investments have long been seen as an exclusive option of institutional investors, providing them with protection in down markets as well as higher returns. Today, innovations in the mutual fund and ETF marketplace have made many of these alternative strategies available to the average investor, but many still have questions about how to incorporate alternatives in their portfolios. The Morningstar Diversified Alternatives Index SM addresses the many inherent complexities of identifying a mix of liquid alternative investments that could be appropriate for many investors. Providing diversification beyond traditional asset classes, this benchmark may be viewed as a guideline for creating a completion portfolio, which, if added to a portfolio of traditional asset classes, has the potential to improve the risk/return profile of the whole portfolio. The index comprises a diversified set of alternative ETFs in the ProShares lineup that dynamically adapt to market conditions and provide a multi-alternative, optimized solution that leverages Morningstar investment research, asset-allocation, and indexing expertise. Alternative Investments Investors have rushed to put billions of dollars in alternative investment strategies, but many still have questions. What are considered alternative investments? What is the benefit of adding them to a traditional portfolio? How much should be allocated to different options? We will take a closer look at alternatives and how they might help investors improve the risk/ return characteristics of their portfolios. Providing diversification beyond traditional asset classes, this strategic beta index may be viewed as the basis for a completion portfolio, which, if added to a portfolio of traditional asset classes, has the potential to improve the risk/return profile of the whole portfolio. What Assets and Strategies Are Considered Alternatives? There was a time when investing could be easily divided into stocks, bonds, and cash. Today though, hedge funds and other alternatives have impacted the investment landscape with sophisticated trading strategies and other approaches. Many hedge fund and other

2 Page 2 of 12 alternative strategies have found their way into registered mutual funds and exchange-traded funds available to retail investors. Defining alternative investments isn t straightforward; even the hedge fund moniker comprises a multitude of strategies, many of which share characteristics with traditional asset classes. Because of this ambiguity, Morningstar defines alternatives as those strategies or asset classes that provide the following: unique sources of risk and return, correlation benefits with traditional stocks and bonds, and ultimately, the potential for a superior Sharpe ratio (or risk-adjusted return) in a portfolio. Portfolio-wide improvement of risk-adjusted returns can be accomplished by allocating to nontraditional asset classes and nontraditional investment strategies. It is also important to note that what is considered an alternative investment today may not be tomorrow. Once an investment becomes mainstream, it may no longer be considered an alternative. For example, listed real estate investment trusts or emerging-markets stocks used to be considered alternatives, but some now consider them traditional asset classes. Therefore, Morningstar s definition of alternative investments can be broken down into two categories: Alternative Alpha Investment strategies that have low correlations to traditional investments. Examples include long/short equity, merger arbitrage, and managed futures. Alternative Beta Asset classes that have low correlations to traditional investments. Examples include global infrastructure and private equity. Alternatives offer a unique set of characteristics compared with traditional asset classes (defined as U.S. stocks and U.S. bonds), making their inclusion in a portfolio potentially beneficial, as they can create a more efficient investment strategy. In the past, investors and advisors have fulfilled their target alternative allocations by applying a homogeneous definition to the different flavors of alternatives. While recognizing the general benefits of alternatives, investors tend to group all alternative asset classes and strategies into one asset class and often implement the target policy by using only one investment vehicle that falls into that general category. This approach is less than optimal because of the variety of alternatives available, each with its own individual characteristics. Mutual funds and ETFs that invest in alternative asset classes have become one of the fastest-growing segments of the industry over the past few years, based on asset flows and new fund launches. Morningstar now has 15 different alternative mutual fund and ETF copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

3 Page of 12 categories, up from just one in 2006, tracking several hundred funds and billions of dollars in assets. Such an array of categories suggests that alternatives are far from being a homogeneous asset class. Using the two categories in our definition, Alternative Beta and Alternative Alpha, Exhibit 1 presents a short description of the seven asset classes that broadly represent the alternative landscape: Exhibit 1 Alternative Alpha and Alternative Beta Alternative Alpha Hedge Fund Strategies Long/Short Equity Merger Arbitrage Managed Futures Investments that mimic alternative strategies often found in hedge funds. Investment strategy that involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value. A type of event-driven investment strategy that simultaneously buys and sells the stocks of two merging companies. An investment strategy that typically involves going long or short in futures contracts for underlying assets such as commodities, currencies, and fixed income. Alternative Beta Breakeven Inflation Global Infrastructure Listed Private Equity Investment strategy designed to profit when the break-even inflation rate determined by subtracting the yield of Treasury Inflation-Protected Securities from the yield of Treasuries rises. Invests in the listed stocks of infrastructure-related companies (transportation, communication, energy, and other essential services) around the world. Investing in companies that engage in venture capital, leveraged buyouts, corporate restructuring, and mezzanine financing or purchasing shares of privately held companies. Properties of Alternatives There are a few takeaways from analyzing the calendar-year returns for the various alternative asset classes for the past 10 years. First, there is a rotation in terms of performance leadership from year to year. For example, in 2008, managed futures were the best performing asset class, while listed private equity was the worst performer out of the seven alternative asset classes previously mentioned. However, in 2009, when the market started to recover after the global financial crisis, listed private equity claimed the highest return while managed futures underperformed all the other alternative asset classes. Second, given the range of returns, it is apparent that diversification among these strategies is essential. Third, several of these alternatives have outperformed U.S. equities, especially during the global financial crisis of Over the past decade, alternative asset classes have shown notable divergences not only in terms of return but also in terms of risk and correlations. For example, listed private equity and global infrastructure have outperformed U.S. equities, providing opportunity for growth copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

4 Page 4 of 12 potential above that of traditional asset classes. Meanwhile, other low-beta alternative strategies such as managed futures or merger arbitrage have displayed significantly less volatility than equities have, providing potential downside protection in a portfolio. The smoother return pattern generated by some alternatives over time is primarily a function of the various hedging strategies that are employed to explicitly mitigate market risk. Examining alternative strategies on their own tells just part of the story. The next step is to consider how they can affect a portfolio s overall risk and return characteristics. Ibbotson Associates, a Morningstar subsidiary, has extensively researched alternative asset classes, including listed private equity, global infrastructure, hedge funds, TIPS, and managed futures. Please see Appendix B for a list of Ibbotson s research papers. Across these alternative asset classes and strategies, our studies show that once alternative assets are introduced into an investment opportunity set, the efficient frontier of possible portfolios shifts outward and upward that is, portfolios become more efficient from a risk/return perspective, as shown in Exhibit 2. The efficient frontier line that incorporates nontraditional asset classes shifts upward because some of the growth-oriented alternative asset classes increase the portfolios expected returns. It shifts outward as lower correlations reduce overall portfolio risk. The net result is increased risk-adjusted returns and more optimal portfolios. Exhibit 2 Illustrative Efficient Frontiers Alternative Traditional Return % High Merger Hedge Funds Long/Short PE Managed Futures Infrastructure Bonds US Stocks Non-US Stocks Breakeven Inflation Low Risk High Source: Ibbotson Associates Though there is now more widespread understanding of alternative investment strategies in the market and general acceptance of their portfolio risk and return benefits, difficulty still remains in researching, selecting, implementing, and maintaining a diversified alternative solution. copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

5 Page 5 of 12 The Morningstar SM Diversified Alternatives Index For more than a decade, Morningstar has been developing index industry firsts and delivering innovative indexing solutions. Built on principles outlined in modern portfolio theory, Morningstar indexes use transparent, rules-based methodologies to create beta and strategic beta indexes that managers can track to provide passive investment opportunities. Our indexes cover all of the market s main asset categories global equities, global bonds, alternatives, and multi-asset. Our newest index, the Morningstar Diversified Alternatives Index, addresses the many inherent complexities of identifying a mix of liquid alternative investments that could be appropriate for many investors. Providing diversification beyond traditional asset classes, this index may be viewed as a guideline for creating a completion portfolio, which, if added to a portfolio of traditional asset classes has the potential to improve the risk/return profile of the whole portfolio. It includes exposure to a diversified set of seven alternative asset classes and could be used by investors to construct an alternatives portfolio and to analyze performance. The index combines strategic and tactical asset-allocation strategies and provides a multi-alternative, optimized solution that leverages Morningstar investment research, asset-allocation, and indexing expertise. Index Methodology There are various ways to build a portfolio with alternative investments. One method is to allocate to a multi-strategy alternative portfolio. Another method is to equally allocate among a set of alternative funds. Yet another, more sophisticated method is to use an optimizer to arrive at a set of optimal allocations that maximize the expected returns for a desired level of risk. The Morningstar Diversified Alternatives Index leverages optimization techniques from Ibbotson Associates, a wholly owned subsidiary of Morningstar, Inc., and a leader in asset allocation. To build the index, the Morningstar Index team uses the seven alternative asset classes that broadly represent the alternative landscape: Hedge Funds Long/Short Equity Merger Arbitrage Managed Futures Breakeven Inflation Global Infrastructure Listed Private Equity copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

6 Page 6 of 12 The index uses a systematic, rules-based, top-down, five-step construction process, which is illustrated in Exhibit : Exhibit Construction Process Capital Market Assumptions Monitor Strategic Asset Allocation Sell Buy Portfolio Construction Dynamic Asset Allocation 1. Capital Markets Assumptions First, asset class and investment strategy performance is examined using a combination of historical data, current market information, and additional analysis. Estimated future returns, standard deviations, and correlations are developed for each alternative investment option. One of the most challenging aspects of working with alternative investments is developing a set of capital market assumptions. Estimating expected return, standard deviation, and correlation coefficients is difficult because of a scarcity of historical data for many of these strategies. Ibbotson Associates uses a sophisticated statistical process to extend asset class benchmarks that do not have complete data histories, but do have a relatively high correlation coefficient with one or more proxies. copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

7 Page 7 of 12 Exhibit 4 illustrates the expected return and standard deviation of the alternative asset classes, the main inputs for creating an optimal portfolio. As depicted in the chart, the seven alternative asset classes have different forward-looking estimates, and therefore they have various roles in an overall portfolio. Listed private equity and global infrastructure are asset classes that could enhance return, while long/short equity, managed futures, and merger arbitrage are risk reducers and could offer protection in a market downturn. Exhibit 4 Illustrative Expected Return and Expected Standard Deviation for Alternatives Return % High Risk Mitigators Return Enhancers Private Equity Long/Short Equity U.S. Stocks Non-U.S. Stocks Merger Arbitrage Hedge Funds Global Infrastructure U.S. Bonds Managed Futures Break-Even Inflation Low Risk High Source: Ibbotson Associates 2. Strategic Asset Allocation Weights Next, the asset class model for the index is created by determining the optimal weight for each alternative asset class as part of an overall investment portfolio. That is, the index is optimized as a completion portfolio, not as a stand-alone investment. A variety of techniques are used in this step, including resampled optimization and sensitivity analysis, to enhance the stability of the asset-allocation recommendations under a variety of market scenarios. Given the variety of the alternatives selected, the optimization process considers how the final portfolio of alternatives is performing within a larger opportunity set consisting of both traditional equities and traditional bonds. For instance, listed private equity and global infrastructure carry higher expected returns, increased volatility, and higher correlation to equities relative to other alternative strategies. Thus, these two alternative asset classes would be attractive replacements in an equity-heavy, growth-oriented portfolio. On the other hand, merger arbitrage and managed futures exhibit fairly low volatility and return expectations, much like a broad bond benchmark, but they are not correlated with the broad bond market. As a result, a merger arbitrage approach might be appealing as a bond substitute for a more conservative investor. copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

8 Page 8 of 12 Exhibit 5 Strategic Weights Asset Class % Hedge Funds 20 Long/Short Equity 18 Merger Arbitrage 17 Managed Futures 10 Breakeven Inflation 10 Global Infrastructure 9 Listed Private Equity 16 Source: Ibbotson Associates. Strategic weights shown are as of the date published and are subject to change without notice.. Dynamic Asset Allocation Momentum Overlay In the next step, a quantitative, rules-based momentum overlay is applied to the strategic weights. Momentum investing can be a powerful tool for investors seeking efficient, diversified portfolios and above-average returns. This dynamic strategy recognizes the tendency of returns to follow patterns in the market and is designed to capitalize on these movements. While it s been well-known in academic circles for two decades, the momentum approach has remained largely undiscovered by investors. Since the first research into momentum investing began in the early 1990s, it s been the topic of hundreds of published academic papers and a focus of research by Ibbotson Associates. The momentum effect has been found in nearly all securities, markets, and asset classes over a range of time periods. There is no single explanation of what creates the momentum effect in asset class returns. Researchers agree that it is shaped by market events and how investors react to them. For example, investors may respond slowly to new information about an investment or be reluctant to change their views on it. In other situations, they may overreact to recent performance, sell winning investments too early, or hang on to laggards too long in hopes of breaking even. This can create price run-ups or drops that will last for a period of time before ultimately leading to a reversal, as shown in Exhibit 6. Exhibit 6 Momentum Effect Momentum Effect Underweight: Sell Overweight: Buy Sell Historical Average Return Buy For illustative purposes only. copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

9 Page 9 of 12 To harness the momentum effect, the Morningstar Diversified Alternatives Index follows a systematic, rules-based process: Evaluate market data for each index constituents over a 12-month period, using a model that signals a buy or sell decision at the asset class level. Overweight the asset classes or strategies with the most positive momentum signals and underweights those showing the most negative trends. Apply a rigorous risk-management process to the tilts to ensure that the final index weights remain within a tight tracking error band compared with the strategic weights. Revisit decisions each month to ensure the strategy stays positioned to respond to changing market trends. 4. Portfolio Construction The index is constructed using seven alternative ProShares ETFs to implement the target asset class model. These seven ETFs target various alternative asset classes such as hedge funds, long/short equities, merger arbitrage, managed futures, breakeven inflation, global infrastructure, and listed private equity. This opportunity set may expand in the future under the authority of the Morningstar Index Committee. Exhibit 7 Index Constituents Asset Class Hedge funds Long/Short Equity Merger Arbitrage Managed Futures Break-Even Inflation Global Infrastructure Listed Private Equity Index Constituent ProShares Hedge Replication ETF ProShares RAFI Long/Short ETF ProShares Merger ETF ProShares Managed Futures Strategy ETF ProShares 0 Year TIPS/TSY Spread ETF ProShares Global Direct Infrastructure ETF ProShares Global Listed Private Equity ETF copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

10 Page 10 of Monitor The index constituents and the strategic weights are reviewed annually, and the strategic weights are adjusted based on updated capital market assumptions. The index is rebalanced monthly based on the momentum overlay. Exhibit 8 illustrates the historical weights of the index since February 200. Exhibit 8 Hypothetical Monthly Weights (January 200 August 2014) Hedge Funds Managed Futures Long Short Equity Merger Arbitrage Breakeven Inflation Global Infrastructure Listed Private Equity 100 % Source: Ibbotson Associates copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

11 Page 11 of 12 Conclusion The Morningstar Diversified Alternative Investments Index uses a systematic, rules-based construction process that combines strategic and dynamic investment strategies to effectively navigate the alternative space. This process is based on Ibbotson Associates expertise in analyzing alternative asset classes and forecasting capital market assumptions. This institutional and disciplined investing methodology guides the index construction process. If used in an asset allocation framework, investment vehicles based on the index have the potential to improve portfolio performance through access to return-enhancing asset classes (upside exposure), to mitigate risk by allocating to low-volatility, low-beta strategies (downside protection), and to offer low correlations to traditional asset classes (diversification). copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and

12 Page 12 of 12 Appendix A: Benchmarks Asset Class Hedge funds Long/Short Equity Merger Arbitrage Managed Futures Breakeven Inflation Global Infrastructure Listed Private Equity Index Constituent ProShares Hedge Replication ETF ProShares RAFI Long/Short ETF ProShares Merger ETF ProShares Managed Futures Strategy ETF ProShares 0 Year TIPS/TSY Spread ETF ProShares Global Direct Infrastructure ETF ProShares Global Listed Private Equity ETF U.S. Equities IA SBBI S&P 500 Non-U.S. Equities MSCI EAFE U.S. Bonds Barclays US Aggregate Bond Appendix B: Published Ibbotson Associates Research Papers on Alternatives The ABCs of Hedge Funds: Alphas, Betas, and Costs (January 2011) Managed Futures and Asset Allocation (February 2005) Infrastructure and Strategic Asset Allocation: Is Infrastructure an Asset Class? (January 2009) Private Equity and Strategic Asset Allocation (January 2008) Passive Options-Based Investment Strategies: The Case of the CBOE S&P 500 Buy Write Index (July 2004) Invest in Direct Energy (February 2002) Commercial Real Estate: The Role of Global Listed Real Estate Equities in a Strategic Asset Allocation (Nov. 2006) TIPS as an Asset Class (November 1999) Strategic Asset Allocation and Commodities (March 2006) Convertible Bonds as an Asset Class: (September 199) The opinions expressed are intended to provide insight or education and are not intended as individual investment advice. It is not intended to be a forecast of future events, or a guarantee of future results. Morningstar does not represent that this information is accurate and complete and it should not be relied upon as such. Although ProShares has entered into a license agreement with Morningstar for the use of the Morningstar Diversified Alternatives Index SM, ProShares is not affiliated with Morningstar. About ProShares ProShares offers the nation s largest lineup of alternative ETFs. ProShares helps investors to go beyond the limitations of conventional investing and face today s market challenges. ProShares helps investors build better portfolios by providing access to alternative investments delivered with the liquidity, transparency and cost effectiveness of ETFs. ProShares lineup of 150 alternative ETFs can help you reduce volatility, manage risk and enhance returns. copied or redistributed, () do not constitute investment advice offered by Morningstar, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and