Alternative Mutual Funds See Continued Growth
By Chris Maxey, Ryan Davis
June 4, 2012
During an especially difficult week, global equity markets were deep in the red, as the S&P 500 Index lost 3.2% and the Dow Jones Industrial Average fell 3.3%.
There was no shortage of disappointing data during the course of the past week, ranging from weakness in the ISM manufacturing survey to an underwhelming May labor market report.
It was such a bad week, in fact, that Bespoke Investment Group found that 18 of the 21 economic indicators released in the U.S. fell short of expectations.
Source: Bespoke Investment Group
In aggregate, economic data has been increasingly disappointing since early in the spring season. At the start of the year, the Citigroup Economic Surprise Index was hovering just above +90. With the latest week making its impact felt, that index is now below -50.
Reviewing the data from last week, it is obvious the overarching trend was negative, but there were a few positive takeaways to keep investors moderately upbeat.
Overshadowed by the Friday release of the labor report was an otherwise optimistic report on consumer income and spending. In the month of April, personal income rose 0.2%, slightly below expectations of a 0.3% increase. Growth in wages and salaries slowed marginally from the month prior, while disposable income also slowed somewhat.
The more encouraging aspect of the report came from consumer spending, which rose 0.3% in April, following a 0.2% increase in March and a 0.9% pickup in February. This suggests that despite anemic growth in income, consumers continue to spend and offer a modicum of support to the overall recovery. One trend to watch is the decline in the savings rate. In order to support recent spending habits, consumers are dipping into savings, pushing the current savings rate down to 3.4%, tied for the lowest reading since 2007.
The biggest overhang for consumers in the post-recession period is the amount of debt on their balance sheets. Last week, the Federal Reserve Bank of New York reported that aggregate consumer debt fell 0.9% between year-end 2011 and the first quarter of 2012. Mortgage debt continues to represent the vast majority of consumer debt with 72% of the overall share.
Source: Federal Reserve Bank of New York
Student loan debt was the only area of growth during the quarter and now accounts for 8% of consumers’ debt load. Overall, student loan debt rose 3.4% and stands at $904 billion.
The entirety of the week revolved around preparing for the May labor report. Unfortunately, it turned out to be supremely disappointing. The economy added a mere 69,000 jobs in the month and the unemployment rate rose to 8.2%. To compound the disappointment, releases for the prior two months were revised down by a combined 49,000.
Across the board, the May labor report was underwhelming. Private sector employers added 82,000 jobs while governments continued to shed workers and lost another 13,000 positions. By sector, manufacturing added 12,000 jobs, but that was easily offset by a loss of 26,000 jobs in the construction sector. Within the service sector, a total of 97,000 jobs was added to the economy with the strongest contribution from health and education. Retail and hospitality both lost jobs in the month.
As mentioned, the unemployment rate ticked up by 0.1% in the month, due to many unemployed returning to the labor pool. The labor force participation rate rose 0.2% to 63.8%, but still remains at levels last seen in the early 80’s. Additionally, the underemployment rate, which includes discouraged workers, jumped 0.3% in May to 14.8%.
Although the latest monthly labor report was highly discouraging for many economists, the broader context continues to be slowly and steadily positive. Compared to the last two recovery periods post-2001 and post-1991, this recovery in jobs is actually not that bad. The economy keeps adding jobs faster than it did after the 2001 recession and only slightly slower than early 90’s recession. That will not do anything to make the 12.7 million unemployed Americans feel any better, but it offers a reminder that we are gradually heading on the right track.
Alternative Mutual Funds See Continued Growth
Alternative investment mutual funds have been one of the fastest growing segments of the investment market in recent years. A generation of investors, rankled by equity market volatility, has turned to alternative investments en masse in search of a new source of return.
Last week, Morningstar and Barron’s released their annual alternative investment survey of institutions and financial advisors. The report revealed asset growth in the industry continued at a strong pace, albeit slower in 2011 than in the year prior. Alternative mutual funds, as defined by Morningstar, experienced inflows of $23 billion in 2011, following inflows of more than $40 billion in 2010. This compared to outflows of $85 billion for US equity mutual funds in the most recent year, as investor faith in equities continued to erode.
This trend is not expected to let up anytime soon. In a study by Cerulli Associates, the firm noted that asset managers anticipate alternative mutual funds will make up 10% of all mutual fund assets in five years. In 10 years, they expect that figure to reach 15%.
The Investment Company Institute estimated that the entire mutual fund industry represented $23.8 trillion at the end of 2011. Reaching a 10% market share would represent a staggering 10-fold increase in alternative mutual fund assets, currently estimated at $214 billion by Cerulli. Given the tripling of assets in this space since 2008, those growth expectations may not be as farfetched as at first glance.
For now, alternative mutual funds remain small in comparison to the overall hedge fund industry. Estimates compiled by Hedge Fund Research indicate that more than $2 trillion in investor capital resided in hedge funds as of the end of the first quarter. Still, given the recent rate of growth, both traditional hedge fund and long-only asset managers have flooded the space with new product.
According to the Morningstar survey, 79 new mutual funds were launched in 2011. This compares to 54 new funds in 2010 and 29 in 2009. Multialternative funds experienced the most rapid increase, with 24 funds launched in 2011 alone. Long/short equity, managed futures, and non-traditional bond followed close behind with a combined 43 funds launched.
Recent fund flows indicate that these are among the more popular strategies with investors. Long/Short Equity funds have taken in net inflows of $1.3 billion so far in 2012, while multialternative funds have taken in $695 million (Morningstar data through April). Managed futures funds took in $350 million, although that trend has reversed in April amid poor performance in the category. Approximately $159 million flowed out of that category during the month.
Indeed, first-time investors in the alternative space may be disappointed in their new investments. The Morningstar managed futures category declined 1.0% year-to-date through May, while the S&P 500 was up over five percent. In the same period, long/short equity funds and multialternative funds added just 55 bps and 49 bps, respectively. Alternative mutual fund returns have generally been lackluster during the past 18 months, although that is also true of the broader hedge fund industry. This likely contributed to slower asset growth in 2011.
Whether or not alternative mutual funds will satisfy investors’ demands remains a major question for the industry going forward. Certain strategies, such as long/short equity, certainly lend themselves to easier replication in mutual fund format, suggesting fund managers should have fewer impediments to achieving their performance objectives. Strategies requiring significant use of leverage (i.e. market neutral) or less liquid investments (i.e. distressed), however, are more difficult to successfully implement via mutual fund structures. Of course, the high fees commanded by hedge fund managers also present a hurdle for alternative mutual funds as compared to traditional asset classes.
Satisfaction will ultimately depend on what investors view as the purpose of their alternative allocations. In an interview with Barron’s, Morningstar Director of Alternative Research Scott Burns noted that survey participants had shifted their focus from “bigger returns” to diversification and non-correlated returns when investing in alternative strategies. This theme was echoed in Cerulli’s report, which noted that the desire to optimize risk-adjusted performance was the primary driver behind interest in retail alternative strategies.
Source: Cerulli Associates
This tenor is a positive shift for both investors and the industry. Alternative investments offer a less volatile path to long-term performance, and should be viewed less as absolute return vehicles. The outsized returns achieved through leverage and highly concentrated bets, made famous by some hedge fund managers, are not realistic outcomes for more constrained mutual funds. Instead, their benefit as producers of less-correlated, independent return streams within a broader portfolio should be highlighted. Of course, daily liquidity in a world of longer-term lock-ups is also a significant bonus.
the week ahead
It will remain a busy week as investors grapple with the unfolding weakness in global risk markets.
In the U.S., important economic releases include the ISM Non-Manufacturing Index, productivity data on Wednesday, Consumer Credit, and finally international trade data on Friday. The Federal Reserve will release its Beige Book on Wednesday, which looks at the state of economic affairs in its numerous districts.
A number of central banks are assembling this week to discuss policy, including those in Australia, Canada, Poland, Europe (European Central Bank), England, Peru and Mexico. The ECB meeting is likely to be the most closely followed, as some investors believe the ECB will act to stem concerns about a financial meltdown in the Euro block. Some have gone as far as calling for a new round of LTRO financing to combat ongoing fears of bank runs in certain peripheral countries.
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