Alternatives Sector Wrap April 2018 · Elliot Lucas Kunal Kotwal, CIMA Matthew Wilkinson Michael...

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Alternatives Sector Wrap April 2018

Executive Summary

This Alternatives Sector Wrap is intended as a both a repository of our latest ratings in the sector, and a

helpful aid to including these strategies in your portfolios. Alternative investments are complex at the

best of times and we plan to provide you with both a deeper understanding of evolutions in the space,

and practical information on a few of the options available.

The first article in this wrap discusses the idea of risk premia. While this is not a recent concept, it is

beginning to enter common parlance in the Alternatives space, as well as in certain equity strategies.

We intend for this article to provide a clearer idea of what risk premia are, why they exist and, how

managers invest in them.

Our second article is a deep dive into our covered universe of diversified alternative funds. These funds

are intended to be a one-stop entry into alternatives as an asset class. However, there are numerous

different possible implementations for such a solution and we discuss the merits of these approaches.

We also provide a brief guide to quantitative evaluation of these strategies' past performance.

Our last article peers deeper into the managed-futures space. While trend-following is generally well

understood nowadays, how it is implemented can vary wildly, whether it be in terms of volatility targets,

actual research, or the overall allocation to 'pure' trend-following. Our aim is to peek under the hood of

our covered managed-futures strategies, to help you pick the right option.

We conclude this sector wrap by outlining our changes to Morningstar Analyst Ratings, and

by detailing changes to our coverage list.

Morningstar Manager Research

05 April 2018

Sector Lead

Elliot Lucas

Contents

1 Executive Summary

2 A Primer on Premia

7 Diversified Futures Three Ways

13 Futures' Future

20 Changes to Morningstar Analyst

Ratings

22 Morningstar Medallists

23 Appendix

Manager Research

Chris Douglas

Director, Manager Research Ratings

Tim Murphy, CFA, CAIA

Director of Manager Research

Manager Research Analysts

Alexander Prineas

Andrew Miles

Anshula Venkataraman, CFA

Elliot Lucas

Kunal Kotwal, CIMA

Matthew Wilkinson

Michael Malseed

Ross MacMillan CA

Sarah Fox

Tim Wong, CFA

Important Disclosure

The conduct of Morningstar’s analysts is

governed by Code of Ethics/Code of Conduct

Policy, Personal Security Trading Policy

(or an equivalent of), and Investment Research

Policy. For information regarding conflicts

of interest, please visit:

http://global.morningstar.com/equitydisclosures

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2018 Morningstar, Inc. All rights reserved.

Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or

distribution. Any general advice or ‘class service’ have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of

Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf.

You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Our publications, ratings and products

should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product’s future performance. To obtain

advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782.

Alternatives Sector Wrap| 5 April 2018 | See Important Disclosures at the end of this report. Page 2 of 24

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A Primer on Premia

Key Takeaways

× This article examines why risk premia exist, how fund managers can exploit them, and hence why

product development has been increasing.

× We explore the question of "What are risk premia?". While there is no one universal definition, there are

common strategies. Here we describe some of these, such as style (carry and momentum) and short

volatility.

× Different managers take different approaches to risk premia investing. We discuss some different

strategies available in the market, to help investors to discern, question, and ultimately understand the

different offerings in the market and what role they can play a role in a portfolio

Risk premia is a ubiquitous term. In a general sense, it refers to a set of strategies that offer sources of

persistent, systematic returns, are grounded in fundamental economic principles, and are backed by

several decades of data and testing. Academic research concludes that three dominant rationales

explain the existence of risk premia opportunities: behavioural biases, structural market inefficiencies, or

compensation for bearing risk. The ‘or’ here is important because it highlights that, much to investor

confusion, no one universal definition of risk premia exists.

While product development in this space has been increasing, opposing views mean risk premia

approaches, and thus product design, can be quite different. And oftentimes, industry rhetoric and

jargon—alternative betas, style premia, factor premia, hedge fund beta—can be conflicting and

haphazard. Our focus here is to explain some of the common risk premia, and the different

implementation methods employed by reputable fund managers in this arena. In doing so, investors will

be able to more clearly identify, discern and question the many offerings that have surfaced in the

industry.

‘Style’ Premia: Carry, Value, Momentum, and Defensive

Let’s start with one of the most common risk premia in the market, carry. It refers to the tendency for

higher-yielding assets to provide higher returns than lower-yielding assets. It’s best known amongst

currency investors—borrowing in a lower interest-rate currency and investing the proceeds in a higher

interest rate currency. In an efficient market, the profit gained from this yield spread should be offset by

Author:

Sarah Fox

Analyst, Manager Research









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the depreciation of the higher-yielding currency (known as uncovered interest rate parity). But decades

of empirical evidence show, at least in the short to medium term, there are persistent departures from

this economic condition. One rationale for this persistent divergence is the existence of other nonprofit-

seeking market participants who pursue exposure to lower-yielding, ‘safer’ assets, such as hedgers.

Such structural inefficiencies can be exploited in other asset classes, such as fixed income (long- versus

short term premium bonds), equities (higher- versus lower-dividend stocks), and credit (credit premium

differentials).

The concept of capturing the carry premium centres on the assumption that market conditions will stay

the same. For example, with the classic currency strategy, if exchange rates do not change, the strategy

will earn a positive return. But it is risky. When financial stress occurs, investors flock to ‘safe’, low-

yielding assets which can force downward pressure on higher-yielding asset prices. Thus, managers

generally diversify carry exposure across asset classes.

Value is possibly the most widely recognised and tested of these styles. First propagated by Eugene

Fama and Kenneth French, academic research demonstrates that cheap assets tend to outperform

relatively expensive assets. Behavioural biases explain some of the persistence of this return source in

that investors tend to overestimate the endurance of growth, which can be exploited. Fund managers

start by constructing a value signal (for stocks, price/book or price/earnings ratio). Then, by ranking the

universe from cheapest to dearest, exposure can be implemented in either a long-only (buy the cheapest

stocks), long-short (buy cheap, sell expensive), or market-neutral fashion.

Momentum is equally well recognised. It is the tendency for an asset’s recent relative performance to

continue. Compelling empirical evidence going back to the 1990s validates momentum’s persistence.

Due to behavioural biases, investors are prone to overact to recent success. Higher prices tend to spur

more buying, leading to the continuation of the trend. By investing in recently outperforming assets and

short-selling recently underperforming assets, fund managers can structure precise exposures to effect

low market correlation and enhance portfolio diversification. Investors need be aware that the well-

known performance profile of momentum comes with occasional but large losses (it exhibits negative

skewness and kurtosis). When an asset’s recent price trend reverses abruptly, the strategy can sell off

dramatically. Hence, managers often pair momentum with uncorrelated and positively skewed strategies

such as value. We shall dissect portfolio construction approaches later in this report.

Last but not least, the concept of the defensive (low beta/low volatility) risk premium has a long history

dating back to 1972, when it was first observed that higher-risk assets offered insufficient compensation

relative to lower-risk assets and thus lower-risk assets have a tendency to outperform. The more

persuasive theories for the defensive risk premium existence are structural and behavioural in nature.

Lower-risk assets require leverage to increase their return expectations. However, many investors fear

the word leverage, or have little capacity to leverage, so they tend to invest in higher-risk assets in the

hope that they will be compensated accordingly. This activity thereby lowers the likely returns of those









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assets. Managers can profit over the long run from taking the other side of these transactions and

investing in the leveraged, lower-risk assets while short-selling the higher-risk assets.

These four factors, generically termed ‘styles’, are probably the most familiar to investors. There is

widespread agreement on their pervasiveness given compelling empirical evidence, economic rationale

and academic examination. They tend to have low correlations with the market and with one another, so

it is typical to see a combination of these different styles in a portfolio to manage risk and enhance

diversification. For example, carry is negatively correlated with the defensive strategy, as is value versus

momentum (as stated above). Additionally, the strategies make wide use of short-selling, leverage, and

derivatives to obtain the return source and tweak exposures. This means implementation, portfolio

construction, and cost control are essential if managers are to competitively extract the benefit from

style investing.

There is disagreement between some market participants as to whether value and defensive can be

defined as risk premia. We’ll get to that later.

Short Volatility and Hedge Fund (or Alternative) Risk Premia

Short volatility is probably lesser known to investors but is increasingly utilised in portfolios. The

general concept is to extract the return differential between implied volatility and realised volatility. It’s

common for market participants to buy protection or hedge against portfolio risks. Fund managers on

the other side of such a transaction can short-sell volatility and obtain an incremental, steady profit

through premia. It can be implemented using call and put options, VIX (U.S. index volatility measure)

futures contracts, and other derivative instruments. While it is widely utilised in equities, it can also be

implemented in fixed income, currencies, and commodities. There is big tail risk here, however—

remember negative skewness and kurtosis. When volatility spikes (such as the 116% surge in the VIX

early in February), this strategy can suffer large losses. Some managers attempt to reduce the

magnitude of these possible losses by incorporating other hedges (such as being short S&P Index

futures to some amount), to maintain a constant risk profile.

Once exclusively in the hedge fund domain, this type of strategy has since become more easily

accessible. There are a variety of strategies that have a similar genesis, commonly termed ‘hedge fund

premia' or 'betas'. To explain the evolution of this phenomena, think about a hedge fund strategy as

originally commanding ‘alpha’, that is, a return that cannot be sourced from any systematic risk factor.

Over time, as more market participants innovate and advance, they can replicate the strategy, effectively

diminishing the alpha. This evolution is depicted in Exhibit 1. The return source still exists, yet it is now

explained by a common, understandable, systematic exposure. Therein lie the premia.









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Exhibit 1 Illustration of the Evolution of Alpha to Premia

Source: AQR Capital Management Ltd

An example of the many hedge fund risk premia is trend-following, implemented using managed

futures or commodity trading agreements. Trend-following is very easy to implement mathematically

and thus vulnerable to becoming commoditised. Indeed, we have seen a proliferation of cheap, set-and-

forget products. Specifically, the strategy uses futures contracts to profit from an asset’s short- and

long-term price trends, closely corresponding to momentum, the style premia explained above. It takes

advantage of investor behavioural tendencies to buy recently outperforming assets and sell recently

underperforming assets.

Different Approaches to Risk Premia

Prominent managers in this space take different views on the definition of risk premia, and thus strategy

implementation differs greatly. Indeed, its common to see a range of different risk-premia combinations

based on correlations in order to manage and diversify risk exposures. AQR distinguishes risk premia

into two groups: style premia and hedge fund premia. AQR WS Delta (17692) employs a range of hedge

fund premia such as merger arbitrage, and style premia such as carry. Others such as BlackRock and

Aspect similarly distinguish the style factors as their own risk-premia grouping, while taking more

bespoke views elsewhere.

Capital Funds Management take a more defined approach to risk premia than the rest of the market. In

their view, risk premia are compensation for assuming negative skewness, or downside risk. As such,

carry and short volatility fall into the risk premia bucket. Conversely, value and trend-following (managed

futures) are not risk premia, because they exhibit positively skewed return profiles. Like their peers

though, CFM blends different risk premia with other positively skewed strategies to manage portfolio

risk. CFM Institutional Systematic Diversified (41062) combines risk premia (carry and short volatility)

Alpha

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with trend-following and a market-neutral strategy sleeve to enhance portfolio diversification and

improve risk-adjusted returns.

While definitional nuances and jargon used in the space can be confusing, risk premia are not a new

concept and its legitimacy and lengthy pedigree mean clients should not be daunted. Like studying a

new language, the initial learning curve is steep, but proper understanding of the idea of risk premia

and how different strategies can be implemented will complete your understanding of how your

alternative investments are managed. As such, it can enrich your conversations around the different

strategies offered in the market.









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Diversified Alternatives, Three Ways

Key Takeaways

× We cover three broad approaches to diversified alternatives investing. All have their pros and cons, but

we believe some have more merit than others.

× Fees should be a key watchpoint for investors in this space, as high fees are a major detractor to overall

returns.

× Alternative investments' performance should be evaluated using a range of metrics, with a particular

focus on their ability to provide lower downside participation and increase portfolio diversification.

Alternative investments are an extremely heterogeneous asset class. Some market environments are

more favourable to certain alternative investment styles than others. For example, managed-futures

strategies fared very well in 2013, when clear trends in equities and fixed income emerged, but they

suffered significant drawdowns in the far choppier markets of 2016. It can be difficult timing and tilting

allocations within this Morningstar Category, so diversified alternatives are a possible solution for

outsourcing this decision-making.

Therefore, for investors seeking to capture a broad range of alternative exposures, and thus smooth the

return profile of their alternative allocation, a strong case can be made for investing in a diversified

alternative strategy.

Author:

Elliot Lucas

Analyst, Manager Research









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What Diversified Alternative Options Exist?

Our coverage in this space can be grouped into three broad classes.

Exhibit 2 Classification of Diversified Alternatives by Investment Style

Source: Morningstar Direct. Data as of 28/02/18.

Fund of Funds

This has been the classic way to gain access to a multitude of hedge-fund/alternative investment

strategies at once. In this structure the manager invests in a portfolio of other single-strategy hedge

funds.

Advantages of this approach:

× It provides easy access to a multitude of hedge fund/alternative strategies.

× Allows access to alternative strategies that are otherwise not easily accessible by retail

investors, such as merger arbitrage, long-short credit, or convertible arbitrage.

× Can be highly diversified, especially if the manager appoints several submanagers to a single

strategy.

× Has some room for the manager to generate alpha and respond to market conditions. For

example, if the manager has skill in picking sub-managers, they may earn returns above the

average manager in that space. Another way to generate alpha is to attempt to identify

which strategies will outperform in a given market environment, and overweight that

strategy.

× As one of the oldest approaches to diversified alternatives, these are among the few strategy

styles with long track records in the Australian market.

Disadvantages of this approach:

× Very high fees owing to the layering of management fees. Starting from the top, investors

must pay a management fee to the fund-of-funds manager they are investing in. Sometimes

this also comes with a performance fee. Then, the fund-of-funds manager will pay

Fund Style Ticker Strategy Name Rating

Fund of Funds 6988 Ironbark LHP Diversifed Investments Neutral

5842 Ironbark Global Diversified Alternatives Neutral

40364 FirstChoice WS Alternatives Neutral

Systematic Hedge Fund Beta 41062 CFM Institutional Systematic Diversified Bronze

17692 AQR WS Delta 1F Bronze

Discretionary Global Macro 40749 Invesco WS Global Targeted Returns A Neutral

40258 SLI Global Absolute Return Strategies Bronze









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management and performance fees to the underlying submanagers. All these fees add up

quickly and diminish the potential return for investors.

× Unless skill in picking managers is high, overdiversification by strategy can lead to average

returns—a problem which is compounded by the layering of fees we mentioned before.

× Timing the market is hard at the best of times, and particularly so in trying to time alternative

strategies. Therefore, managers who attempt alternative-strategy timing are introducing

additional risk to the portfolio.

× Correlation to equities has tended to be low, except in times of equity market stress—which

is exactly when investors would want lower correlations from their alternative funds.

× It can be difficult to disaggregate alpha returns from beta returns.

Overall, while we are sympathetic to what these strategies are attempting to accomplish, we think that

the cons outweigh the pros in this space, and we do not recommend any strategies of this type

currently.

Quantitative Alternative/Hedge Fund Beta Strategies

These strategies use quantitative models to replicate hedge-fund strategies or access alternative betas,

as described in our previous article 'A Primer on Premia'. This space is becoming especially popular in

recent years, as the multiplication of risk-premia offerings continues.


× The quantitative process lends itself well to repeatability and consistency.

× There is ample academic research backing the investment approach.

× Can carefully tailor the portfolio to help achieve the desired outcomes.

× Less dependence on day-to-day decision-making to achieve results.


× Fees here remain expensive, but less so than in fund of fund structures.

× Little opportunity for alpha in excess of alternative-beta exposure when compared with an

active manager.

× Often dependent on careful implementation and ongoing research.

We are quite amenable to this approach, as indicated by our ratings in this space. We are particularly

enthused about the careful risk-management employed, as well as the repeatability of the process, both

of which we believe are especially essential to a successful outcome for alternative strategies.

Global Macro Strategies

These kinds of strategies aren't new to the Australian market, but they have become more in vogue

recently, and we have seen a bevy of both systematic and discretionary macro offerings coming to

market in the past few years. These strategies tend to have explicit cash+ targets, stringent volatility

limits, and an explicit aim to limit downside participation.









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The two strategies we cover currently are both discretionary global macro, meaning they focus on

fundamental analysis of macroeconomic conditions. Portfolio managers weigh up the pros and cons of

varying positions in order to reach their investment objectives. The investment universe is extremely

broad, covering almost any liquid asset class.


× Fees tend to be amongst the lowest in the Alternatives category.

× Explicit focus on downside protection is a key differentiator compared to the other strategies

here.

× Has significant diversification across asset classes.

× These strategies tend to be part of much larger businesses with ample resourcing to support

the complicated investment strategies employed.


× The process here is extremely complex and relies heavily on manager ability to repeatedly

make correct macroeconomic calls.

× The explicit downside protection target can sometimes conflict with the return target, and

we have seen that these funds tend to significantly undershoot their volatility budgets, and

as such their return targets (despite maintaining a laudable smoothness to their return path)

× The vast informational flows needed to run this kind of strategy mean the team must be

properly integrated within the business it operates in, which can be challenging if incentives

are not correctly structured.

Overall, we believe this type investment strategy has merit, particularly given the explicit aim to limit

downside, and generally lower fees for an alternative investment. But careful selection of the right

manager remains essential given their complexities.

What to look for when picking a fund in this space?

We think your first port of call when looking to invest in the diversified alternatives space should be our

qualitative fund reports. As you’d expect, we recommend you focus your efforts on Morningstar

Medallist funds.

However, when doing your own research, we think looking at a few quantitative metrics can also be

helpful to assess the past performance of a strategy and observe whether it has performed in line with

its intended objectives.

The biggest challenge to this remains the short performance histories of these funds, but this is

becoming less of an issue. We’d suggest looking at quantitative metrics over at least five years, and the

longer the better, especially if you can observe performance of these strategies over an equity bear









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market. This would be particularly enlightening, as it is in equity bear markets that you most need the

diversification benefits provided by alternatives.

A few useful metrics include:

× Sharpe Ratio: Measures the return above cash per unit of risk of the investment. High

Sharpe ratios indicate that an investor is adequately compensated for taking on risk in this

investment.

× Sortino Ratio: This is very similar to the Sharpe ratio, but it measures the return to volatility

caused by negative returns. A higher Sortino ratio is better, and especially for an alternative

strategy, is a useful measure of the fund’s defensive attributes.

× Correlations/Beta to Major Equity Indexes: For an alternative strategy to be worthwhile, it

must provide adequate diversification to major risk assets, which in most cases will be

Australian and international equities. We’d recommend investors seek strategies with

correlations to these indexes of below 0.5, and preferably lower. Of particular note is to look

out for variations in correlations—looking at bear correlations is particularly useful in this

case.

This table aggregates these five-year metrics for funds with sufficiently long histories under coverage:

Exhibit 3: Five-Year Risk Metrics to 31 Dec. 2017; Correlations Measured Against the MSCI World NR AUD


A few comments on the above information. From a pure return, Sharpe, and Sortino ratio point of view,

the Ironbark LHP Diversified Investments (6988) fund is especially impressive, and it has a pleasingly low

beta to the MSCI World NR AUD. However, its beta during more stressful environments, as measured by

‘bear beta’ suddenly surges, indicating it might not have as much diversifying potential as it might

initially seem.

On the other hand, the AQR WS Delta (17692) fund has near zero correlation to equities in general, and

its bear correlation is actually negative, meaning this strategy has been a genuine diversifier for an

investor’s portfolio in a range of market environments.

Ticker Return

Sharpe

Ratio

Sortino

Ratio Correlation

Bear

Correlation Beta Bear Beta

Ironbark LHP Diversified Investments 6988 7.57 1.88 3.94 0.45 0.59 0.12 0.48

Ironbark Global Diversified Alternatives 5842 4.09 0.62 0.99 0.53 0.24 0.15 0.16

AQR WS Delta 1F 17692 4.63 0.85 1.53 0.12 -0.24 0.03 -0.21

SLI Global Absolute Return Strategies Tr 40258 5.42 0.83 1.28 0.61 0.65 0.22 0.71









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Parting Words

This is a complex space, with many approaches to similar objectives. The actual results from these

strategies have been mixed, and few have genuinely been able to provide sufficient portfolio

diversification to justify their often-elevated fees.

Still, there are certain strategies we think are worthy of consideration, and we intend for this article to

both clarify the investable universe and provide a guide to reading our reports and evaluating these

funds quantitatively.









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Futures' Future

Key Takeaways

× The managed-futures space continues to evolve, with some managers such as Winton and Aspect using

non-trend signals to complement their price momentum inputs.

× Trend-following across asset classes has boasted strong Sharpe ratios throughout history. However,

ballooning assets may change the dynamics of this persistent Sharpe ratio into the future.

× Managed-futures funds' return profiles can clump and be volatile depending the type of solution.

Investors need to understand this to ensure they assign the appropriate time horizon when judging

success.

× Higher-volatility offerings are expected to have higher drawdowns, but may also have higher upside

capture in trending markets.

Within the Australian alternatives investment landscape, managed-futures strategies are amongst the

most popular exposures for investors. It seems the confluence of cheaper entrants such as CFM IS

Trends, combined with strong return profiles from programs such as Winton Global Alpha through the

financial crisis, are giving investors comfort in the persistence of returns from momentum-based

strategies.

Firstly, lets recap what a managed-futures strategy is. Managed futures are trend-following programs

that use futures contracts to allocate to markets across all asset classes which are experiencing

sustained movement up (long investment) or down (short investment). Futures funds also use leverage

to vary positioning depending on their conviction level.

As investor conviction increases in trend-following programs, it may surprise many to know that models

are evolving, and programs such as Aspect Diversified and Winton Managed futures offer less trend-

following exposure than one may expect. While we don’t cast judgement either way, we wish to outline

the spectrum of choice available and hypothesise about why some programs may have decided to

supplement their trend models with other premia.

Author:

Kunal Kotwal, CIMA

Senior Analyst, Manager Research









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Exhibit 4 Breakdown of Risk Allocation

Source: Morningstar Manager Research. Data as of 31/12/17

These are long-term risk allocations and can vary over shorter time periods.

**AQR use overextension inputs to manage conviction and sizing of signals.

*Non-Trend allocation may include but is not restricted to Carry, Relative Momentum, Value, Seasonality, and Macro.

As can be seen from Exhibit 4, programs such as Winton and Aspect allocate materially to non-trend

signals. One key difference between the two, however, is Aspect has always had 20% risk weighting to

modulating factors (non-trend) since inception of the program, whereas Winton’s exposure to non-trend

signals has grown over time. In fact, since 2011 Winton’s non-trend exposure has increased from 15% to

40%. Why would programs implement non-trend signals and what does this mean for pure trend-

following strategies?

We see two primary reasons why funds such as Winton and Aspect have chosen to allocate to non-

trend signals to complement their trend-following models: 1) Reduction in risk adjusted return (Sharpe

ratios) from pure trend-following, and 2) To reduce the lumpy return path associated with trend-

following.

Sharpe ratios are very important for managers within this space and directly affect how portfolios are

positioned. While Sharpe ratios are dynamic, they do provide managers an insight into the efficacy of a

trend-following model across multiple asset classes. On average, the expected Sharpe ratio from trend-

following is around 0.6 to 0.7, though these are gross figures and fees and implementation costs can

materially affect the net outcomes. An exponential increase in assets within this space can have a

significant impact on Sharpe ratios, as trend-crowding can manifest due to the magnitude of players

looking to exploit the same anomaly which would naturally erode Sharpe ratios. Asset bloat can also

increase transactions costs due to natural and steady turnover in managed futures funds stemming from

their look back profiles. These transaction costs can also materially spike in times when the program

needs to change directions under stress environments in particular markets.

Name of Strategy Allocation to Trend Following Non-Trend Allocation* Expected Volatility

AQR Managed Futures 100% Nil** 17%

Aspect Diversified 80% 20% 17%

Winton Global Alpha 60% 40% 8-12%









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Exhibit 5 Results of AQR’s Back-Test to Determine Individual Sharpe Ratios From Jan 1880-Dec 2016

Source: AQR Capital Management. Data as of 31/12/16.

Trend-following return tends to clump, which means feast or famine type of outcomes can persist over

multiple years. These programs are very sensitive to trendless and whipsawing markets, whereby trends

emerge only to change direction prior to the program having meaningful allocation. Prominent

institutions are aware of this shortcoming, and in the case of Winton and Aspect have looked to

introduce other inputs to reduce the lumpiness of returns and make longer-term investment in these

funds more palatable for investors.

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LEA

DED

ZIN

C









Page 16 of 24

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Exhibit 6 Return Profiles of Managed Futures From 2007 to 2016


Perspectives From Managers

When we posed our sentiments to the managers within this space, the feedback was mixed. CFM, AQR,

and Aspect stated that current data didn’t show any material degradation of Sharpe ratios. Conversely,

Winton suggested a decrease in net Sharpe ratios was to be expected stemming from the issues

outlined above. Winton believed some faster-term trend-following models may need to slow down their

programs to combat the increase in turnover costs to maintain compelling returns. This means faster-

term trend-following models have materially less capacity than medium- and slower-trend followers.

Aspect mentioned while it doesn't see material reductions in Sharpe ratios from trend-following,

combining this with other premia such as value, carry, or seasonality makes sense, as it improves the

overall diversification and thus offers a smoother overall journey for investors. The reason is that the

payoff profiles (timing and magnitude) of trend and non-trend signals will be different.

While AQR acknowledged that adding other premia can improve absolute Sharpe ratios, they outlined

that the resultant allocation can be more correlated to risky assets in down markets, leading to less-

transparent outcomes. They believe that the management of this correlation to equity down markets is

better combatted within the pure trend-following program rather than through a hybrid structure.

However, AQR’s answer to reducing the sensitivity to inflexion points is by incorporating ‘overextension’

signals while aiming to increase/decrease exposure to signals based on the length of the trend.

CFM, whose futures strategy was recently added to Morningstar Prospects, mentioned that trend-

following continues to boast strong returns and risk characteristics. However, the rise of assets and

participants within this space has led to the commoditization of alpha, which should manifest into lower

-15

-10

-5

0

5

10

15

2007

-06

2007

-09

2007

-12

2008

-03

2008

-06

2008

-09

2008

-12

2009

-03

2009

-06

2009

-09

2009

-12

2010

-03

2010

-06

2010

-09

2010

-12

2011

-03

2011

-06

2011

-09

2011

-12

2012

-03

2012

-06

2012

-09

2012

-12

2013

-03

2013

-06

2013

-09

2013

-12

2014

-03

2014

-06

2014

-09

2014

-12

2015

-03

2015

-06

2015

-09

2015

-12

2016

-03

2016

-06

AQR Wholesale Managed Futures 1P Winton Global Alpha Aspect Diversified Futures-Class A









Page 17 of 24

Page 17 of 24

Page 17 of 24

fees for such strategies. This is interesting as historically futures shops have pointed to research

firepower as one of the key reasons for the ‘premium’ being paid. However, any incremental benefits to

performance can be minute and easily erased by the fee. CFM thinks that capturing most of the returns

within this space with lesser complicated models at a lower price would lead to better net outcomes for

investors due to less erosion of return coming from the fee.

Given the above perspectives, it is hard to draw any concrete conclusions. However, what is pleasing is

that the above evolution of the sector has meant investors have options to cater for a wide variety of

fees, volatility levels, and program designs (trend versus non-trend).

Considerations

We think the main points from a quantitative perspective to consider when selecting managers are cost,

volatility, and correlations. From a qualitative perspective, it is critical for investors to be comfortable

with the volume and depth of the intellectual firepower within the firm, as these models do need

varying degrees of maintenance and innovation to maintain their edge.

While we tackle these concepts separately they are very much interlinked, and investors need to find

the right balance/mix between them.

With regards to costs, we are seeing some positive developments within the space, such as CFM’s low-

cost trend-following program (0.8% management expense ratio with a 10% performance fee) and

Winton’s modest fee reduction in June 2017 (10-basis-point reduction). Investors are seeing a spectrum

of different options across multiple fee points, with CFM and AQR being the cheapest, while Aspect and

Winton are the most expensive. If even a small part of the above discussion is to be believed (erosion of

Sharpe ratio), managed-futures offerings must continue to price appropriately to ensure investors

achieve a strong net performance outcome.

Volatility, particularly to the downside, is also a key consideration when allocating to this space and

levels should be carefully selected to match investor tolerances. As mentioned above and illustrated in

Exhibit 6, returns within trend-following can clump. This feast or famine return path can prompt many

investors to capitulate on their allocations after suffering multiyear lacklustre returns, only then not to

participate in the snap back. Understanding the tolerance of investors to drawdown is critical in

selecting the right volatility target, shown in Exhibit 7.









Page 18 of 24

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Page 18 of 24

Exhibit 7 Drawdown Profiles of Managed-Futures Programs


For investors who are more sensitive to drawdowns, a lower volatility offering with a higher exposure to

non-trend signals may be a better fit. Conversely, for higher-risk investors it may be appropriate to

allocate to a higher-volatility fund with fewer non-trend signals or a pure trend-following model. As with

most things there always exists a trade-off between returns and risk, so it is worth mentioning that

while lower volatility funds are expected to have lower drawdowns, they should also be expected not to

participate in the upside as much as higher-volatility strategies.

Investors also have a choice between higher or lower allocation to non-trend signals. While the addition

of non-trend signals can manifest into a smoother return journey through market inflection points, an

allocation to non-trend signals can also reduce returns in an environment that is accretive to trend-

following. One final point to note here is that non-trend signal allocation adds another layer of

complexity that needs to be managed.

Finally, we urge investors to carefully consider and understand the correlation benefits of these

strategies relative to global equities. As shown in Exhibit 6, correlations to global equities are dynamic

and can change dramatically, swinging between positive and negative. While there is no right answer

on which correlation level is appropriate, we urge investors to monitor this on an ongoing basis to set

diversification expectations in down markets. A practical example is using a managed-futures strategy

that exhibits a high equity correlation may provide little diversification to an equity-heavy portfolio if

there is a sharp sell-off in equities in the near term.

-30.0

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

1/06

/200

7

30/0

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07

31/0

1/20

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31/0

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30/0

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31/0

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31/0

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31/0

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30/0

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11

31/0

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30/0

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31/0

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31/0

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30/0

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31/0

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31/0

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30/0

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31/0

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14

31/0

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30/0

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31/0

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31/0

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30/0

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30/0

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31/0

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31/0

5/20

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30/0

9/20

17

Winton Global Alpha AQR Managed Futures Aspect RBA Bank accepted Bills 90 Days









Page 19 of 24

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Page 19 of 24

Exhibit 8 Correlations to Global Equities


We appreciate managed futures strategies can be difficult to understand and not immensely

transparent at the best of times. In this piece we have sought to bring out some of the evolution

happening at the program levels and provide some rare perspectives from the managers themselves.

While there is no perfect allocation, alternative strategies such as managed futures can provide a

differentiated risk and return driver to portfolios, and are worth a look as a potential allocation within

investors' alternatives exposure.

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

2007

-07-

01 to

200

8-06

-30

2007

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2009

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01 to

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01 to

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1-02

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2010

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01 to

201

1-06

-30

2010

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01 to

201

1-10

-31

2011

-03-

01 to

201

2-02

-29

2011

-07-

01 to

201

2-06

-30

2011

-11-

01 to

201

2-10

-31

2012

-03-

01 to

201

3-02

-28

2012

-07-

01 to

201

3-06

-30

2012

-11-

01 to

201

3-10

-31

2013

-03-

01 to

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4-02

-28

2013

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01 to

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4-06

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2013

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01 to

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01 to

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-28

2014

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01 to

201

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-30

2014

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01 to

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-03-

01 to

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-29

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-30

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-31

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01 to

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7-02

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01 to

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-30

2016

-11-

01 to

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7-10

-31

AQR Wholesale Managed Futures 1P Aspect Diversified Futures-Class A Winton Global Alpha









Page 20 of 24

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Page 20 of 24

Changes to Morningstar Analyst Ratings

We take a medium- to long-term outlook when determining qualitative recommendations. Our views

about the merits of investment strategies move over time based on manager-specific factors such as

investment team composition, changes to investment process, and our degree of relative conviction.

In this review, we covered a total of 15 distinct strategies. We upgraded our Morningstar Analyst Rating

on two strategies; ceased coverage of one strategy; and initiated coverage on two strategies. Two of the

strategies under coverage have not yet received ratings by the time of publishing this sector wrap.

Exhibit 9 Changes to Morningstar Analyst Ratings

Source: Morningstar Direct

Upgrades

CFM Institutional Systematic Diversified

We upgraded CFM Institutional Systematic Diversified to a Morningstar Analyst Rating of Bronze from

Neutral. This has stemmed from our growing conviction in the robust research and insightful portfolio

construction on offer here. The research team at CFM is impressive, and senior staff are long-tenured.

We appreciate the careful implementation of different hedge fund strategies, which should blend well

to provide positive outcomes in a range of market environments. Despite these positives, further

enthusiasm is tempered by the elevated fee.

Strategy Ticker Old Rating New Rating

Upgrade

Aspect Diversified Futures 17744 Neutral Bronze

CFM Institutional Systematic Diversified 41062 Neutral Bronze

New Coverage

JPMorgan Global Macro Opportunities 41086 - Bronze

Ironbark LHP Global Long/Short W 6992 - Neutral

Ceased Coverage

Ironbark Gavekal Asian Opportunities 18365 Neutral -









Page 21 of 24

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Page 21 of 24

Aspect Diversified Futures

We upgraded Aspect Diversified Futures to a Bronze rating from Neutral. This is in recognition of their

dedication to ongoing research and development of their product, as well as the renewed stability in the

team's senior ranks. Aspect provides a higher-risk higher-return managed-futures option, with some

further diversification thanks to an allocation to non-trend signals (modulations). Furthermore, the

outcomes of this strategy have been in line with expectations, which further cements our view.

New Coverage

JPMorgan Global Macro Opportunities

We initiated coverage of JPMorgan Global Macro Opportunities with a Bronze rating. J.P. Morgan

boasts a clear thematic-focused approach which we find robust. In the discretionary macro space we

cover, J.P. Morgan also has one of the best structured teams and incentives, which ensures ideas flow

through to the portfolio managers. While the recent departure of one of the portfolio managers was a

loss, the resourcing here remains impressive, and we think this punchy approach to global investing has

definite merit.

Ironbark LHP Global Long/Short W

We initiated coverage of Ironbark LHP Global Long/Short W with a Neutral rating. Lighthouse Partners is

a U.S.-based hedge fund of funds manager, and this strategy follows a multimanager long/short equities

approach. The commendable committee-structured teams are experienced and effective at identifying

skilled hedge funds underlying this strategy, and the solid full-cycle returns are reflective of this.

However, we cannot overlook the very expensive fee structure and ongoing turnover at the team level.

Dropped Coverage

Ironbark Gavekal Asian Opportunities

We ceased coverage on Ironbark Gavekal Asian Opportunities as this vehicle failed to meet our criteria

for ongoing research.









Page 22 of 24

Page 22 of 24

Page 22 of 24

Morningstar Medallists

Exhibit 10 Morningstar Medallists


We designated eight of the 15 Alternatives strategies we assessed as Morningstar Medallists. One

strategy attained Silver, and we designated a further seven as Bronze. One of these strategies' ratings

comes from a previous rating cycle as it was rated out of our usual Alternatives ratings schedule.

Exhibit 11 Graph of Morningstar Analyst Ratings


Name Ticker Morningstar Analyst Rating

Winton Global Alpha 15811 Silver

AQR Wholesale Managed Futures 1P 19089 Bronze

AQR WS DELTA 1F 17692 Bronze

Aspect Diversified Futures-Class A 17744 Bronze

CFM Institutional Systematic Diversified 41062 Bronze

JPMorgan Global Macro Opportunities 41086 Bronze

Partners Group Global Value (AUD) 19437 Bronze

SLI Global Absolute Return Strategies Tr 40258 Bronze









Page 23 of 24

Page 23 of 24

Page 23 of 24

Appendix 1

Exhibit 12 Morningstar Alternatives Coverage List

Source: Morningstar Direct. Data as 28/02/18.

Name Ticker Morningstar

Analyst Rating

Global Fund Report

Analysis Date

Indirect Cost

Ratio (ICR)

Acadian Defensive Income - Class A 17007 Neutral 10/01/2018 0.45

AQR Wholesale Managed Futures 1P 19089 Bronze 30/01/2018 1.34

AQR WS DELTA 1F 17692 Bronze 18/03/2018 1.40

Aspect Diversified Futures-Class A 17744 Bronze 9/01/2018 2.54

Bennelong Kardinia Absolute Return 19493 Neutral 14/01/2018 1.56

CFM Institutional Systematic Diversified 41062 Bronze 21/12/2017 1.07

FirstChoice WS Alternatives 40364 Neutral 19/12/2017 2.26

Invesco WS Global Targeted Returns A 40749 Neutral 14/08/2017 0.95

Ironbark Global Diversified Alternatives 5842 Neutral 2/02/2018 2.14

Ironbark LHP Diversified Investments 6988 Neutral 29/01/2018 3.73

Ironbark LHP Global Long/Short W 6992 Neutral 30/01/2018 4.47

JPMorgan Global Macro Opportunities 41086 Bronze 26/02/2018 0.98

Partners Group Global Value (AUD) 19437 Bronze 14/01/2018 3.19

SLI Global Absolute Return Strategies Tr 40258 Bronze 4/06/2017 1.16

Winton Global Alpha 15811 Silver 21/12/2017 1.88









Page 24 of 24

Page 24 of 24

Page 24 of 24

Copyright, Disclaimer and Other Information

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Morningstar Research Limited, subsidiaries of Morningstar, Inc.

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All care has been taken in preparing this report. However, please note we base our financial product research on current

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