Wide Dispersion of Returns Drives Need for Greater Expertise

Wide Dispersion of Returns Drives Need for Greater ExpertiseU.S. stocks began 2016 in a bear market, and although volatility has recently subsided, some investors are betting on a return of further market fluctuations – or at least seeking to protect their portfolios against that possibility. This, according to Jonathan Belanger, Director of Research at AlphaCore Capital, is a good reason to take a look at alternative investments.

Dispersion Explained

Mr. Belanger is the author of a short AlphaCore Insights white paper looking at dispersion in alternative investment returns. He explains that dispersion refers to “the scattering of values of a frequency distribution from an average,” and cites the Gaussian distribution as a “normal distribution.”

Gaussian distribution

But not all distributions are “normal,” and when they’re not, it’s important to know. For instance, imagine packing for a vacation based on the “average” daily temperature of 60 degrees, but realizing later that the “average” was based on one 10-degree day followed by 110 degree temperatures the following day! Such a distribution of temperatures would result in a 60-degree average, but a very non-Gaussian, or non-normal, curve.

Market Risk vs. Manager Risk

Alternatives tend to have much wider distribution curves than funds that invest in traditional investments. This is because traditional investment funds typically use a cap-weighted index as a benchmark, to which most funds cling relatively closely. But alternative funds largely eschew benchmarks and are thus more manager-driven. For this reason, Mr. Belanger equates investing in alternatives as “trading market risk for manager risk.”

Dispersion of Sharpe ratios in alternative strategy mutual funds

The image above shows the comparatively tight distribution in the Sharpe ratios – a measure of risk-adjusted returns – of “Large Blend” mutual funds (black line). The Large Blend category is a proxy for cap-weighted funds, and their Sharpe ratios are mostly clustered within 1 standard deviation of the average. By comparison, market neutral, multialternative, long/short equity, nontraditional bond, and managed futures funds had much wider dispersion. The image below shows the dispersion of returns among alternative strategy funds in 2015:

Dispersion in alternative category returns in 2015

How and why an alternative manager is successful (or underperforms) is the most important part of the manager-selection process, according to Mr. Belanger, and for this reason, he “humbly suggests” that investors rely on “an expert” for accessing the alternative strategy space.

For more information, click here to download the full paper.

Past performance does not necessarily predict future results.
Jason Seagraves contributed to this article.