Mainstreaming Alternative Investments

× Nadia Papagiannis, CFA

Alternative Investments Strategist

December 1, 2009

© 2006 Morningstar, Inc. All rights reserved.

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 Morningstar’s Coverage of Alternative Investments

× Institutionaldatabase products:
× Morningstar® DirectSM
× Morningstar® Alternative Investment CenterSM
× 8000 hedge funds, including 3000 fund of funds.

× Alternative mutual funds, ETFs, closed end funds, and

separate accounts.
× 330 datapoints, including Form ADV and 13-F holdings.
× Proprietary Indexes:
× 27 Morningstar Hedge Fund Indexes and 190 Morningstar
MSCI Hedge Fund Indexes.
× 5 Morningstar Commodity Indexes.

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 Morningstar’s Coverage of Alternative Investments (continued)

× MorningstarRatingsTM:
× Hedge funds with 38 months of data.
× Mutual funds and ETFs with 36 months of data.

× New Operational Risk Indicator for hedge funds.

× Alternative Investments Observer quarterly newsletter.

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 Flood of New Alternative Investments

× New “alternative” funds have flooded the US market place in the last decade, in
both mutual fund and ETF form.
× Morningstar tracks 346 such funds, 141 mutual funds and 205 ETFs.
New Alternative Funds

120

100

80

60

40

20

0
77

78

00
85

01

02

03
89

90

91

94

95

97

98

99

04

05

06

07

08

09
19

19

19

20

20

20

20
19

19

19

19

19

19

19

19

20

20

20

20

20

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Number of New Alternative Funds

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 Investors Appetite for Alternative Mutual Funds

× Flows in to alternative mutual funds have grown rapidly in 2009, especially in

the Long-Short category.
US Alternative Mutual Fund Flows

12,000

10,000

8,000

6,000
$ millions

4,000

2,000

-2,000 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
YTD
-4,000

Bear Market Currency US Long-Short

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 Investors Appetite for Alternative Mutual Funds

× Long-Short mutual funds are also the fastest growing alternative category.
Long-Short Mutual Fund Launches

25

20

15

10

0
77

00

02

04

06

08
89

91

97

20

20

20
19

19

19

19

20

20
New Long-Short Mutual Funds

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 Morningstar’s Alternative Mutual Fund Categories

× Long-Short, Bear Market, and Currency:

× Long-Short funds use shorting, but remain net-long or neutral

in exposure.
× Bear Market funds take a net-short equity exposure, and can
be leveraged.
× Currency funds trade spot currency, forward or future
contracts, ETFs, or money market instruments.

× The Long-Short category exhibits the greatest diversity.

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 Breakdown of Long-Short Category

× Option/Buy-writestrategies
× Gateway, Calamos Market Neutral, The Collar funds.

× Non-directional strategies
× Arbitrage strategies:
× Arbitrage, Merger, and AQR Diversified Arbitrage.
× Equity market neutral strategies:
× Highbridge Statistical Market Neutral, JP Morgan
Market Neutral, TFS Market Neutral.

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 Breakdown of the Long-Short Category (continued)

× Long-short equity funds

× Directional shorts: Diamond Hill Long-Short.
× Hedgers: Hussman Strategic Growth.

× Credit strategies
× Forward Long/Short Credit Analysis.

× Commodity or diversified managed futures strategies

× Rydex/SGI Managed Futures Strategy, Direxion Commodity
Trends Strategy.

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 Breakdown of the Long-Short Category (continued)

× Multi-Strategy
× Van Eck Multi-Manager Alternatives, Aston/Lake Partners
Lasso Alternatives, Absolute Strategies.

× Absolutereturn is neither a category nor a way to distinguish

investments.

× Alternativefunds act differently based on asset class/instruments

used and trading strategy.

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 Morningstar’s Definition of Alternative Investments

× Alternative
Investments should provide:
× Positive risk-adjusted returns over time.
× Lower correlation to traditional stock and bond portfolios.
× How do investments meet this criteria?
× Investing in different asset classes/instruments.
× Shorting or hedging.
× What we do not consider alternative:
× Equities with commodity exposure.
× REITS.
× 130/30 strategies.
× Emerging market stocks or bonds.

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 Correlation of Various Investments to a 60/40 portfolio

× A 60/40 portfolio comprised of the I-shares S&P 500 Index and the Barclays
Aggregate Bond ETF incepted in October 2003 and rebalanced quarterly.

1 2 3 4 5

1 60-40 Portfolio

2 Vanguard Precious Metals and Mining 0.71

3 Vanguard REIT Index Inst 0.78 0.56

4 S&P 500 130/30 Strategy TR 0.97 0.71 0.74

5 Vanguard Emerging Mkts Stock Idx 0.84 0.86 0.60 0.83

6 JPM EMBI Global Diversified TR USD 0.72 0.68 0.60 0.66 0.69

Date: 10/1/03-9/30/09 1.00 to 0.60 0.60 to 0.20

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 Drawdowns Relative to a 60/40 portfolio

Max # of
Maximum Drawdown Oct. 2003 to Sep. 2009 Drawdown Periods Peak Date Valley Date

60-40 Portfolio -31.86 16.00 11/1/2007 2/28/2009

Vanguard Precious Metals and Mining -68.86 6.00 6/1/2008 11/30/2008

Vanguard REIT Index Inst -66.59 23.00 4/1/2007 2/28/2009

S&P 500 130/30 Strategy TR -47.56 16.00 11/1/2007 2/28/2009

Vanguard Emerging Mkts Stock Idx -62.70 16.00 11/1/2007 2/28/2009

JPM EMBI Global Diversified TR USD -21.81 5.00 6/1/2008 10/31/2008

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 Commodities as Alternative Investments

× Commodities are a trading strategy rather than an asset class or a

“beta.”
× Investors access commodities primarily through exchange-
traded futures contracts.
× Futures contracts have a net supply of zero, and therefore
there is no “market portfolio” as there is in stocks and bonds.
× The S&P GSCI and the Dow Jones UBS indexes exhibited high
correlations to stocks and bonds in 2008.
× Better “alternatives” to commodity investing:
× Long-short commodity or diversified managed futures trading
strategies.
× An active approach using ETFs/ETNs.

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No Such Thing as a Commodity Beta

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 How to Invest in Alternative Mutual Funds--Do Your Homework!
Correlations (monthly) Oct. 2003 to
Sep. 2009 1 2 3 4

× Not all alternatives are created 1 60-40 Portfolio

equal.
2 US OE Bear Market -0.96

3 US OE Currency 0.31 -0.26

× The average long-short mutual
4 US OE Long-Short 0.91 -0.88 0.32
fund is highly correlated to
stocks. 5 Morningstar Long/Short Commodity TR -0.24 0.20 0.04 -0.06

× Bear market funds show poor Sortino Ratio (monthly) Oct. 2003 to
risk-adjusted returns on Sep. 2009
average. 60-40 Portfolio 0.24

US OE Bear Market -0.85

× Long/short commodity works,
US OE Currency 0.45
but the few funds that exist do
not have long track records. US OE Long-Short -0.10

Morningstar Long/Short Commodity TR 0.96

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 Addition of Select Long-Short Mutual Funds to a 60-40 Portfolio

× Example of a 20% allocation to long-short hedged equity fund, market-neutral fund,

and a managed futures fund.
× Both the returns and the downside deviations were improved in all three portfolios.

Sortino Ratio Sortino Ratio

Inception Max Oct. 03 to Apr. 07 to
Date Drawdown Sep. 09 Sep. 09

60-40 Portfolio 10/1/2003 -31.86 0.24 -0.33

40-20-40 Hedged Equity Portfolio 10/1/2003 -22.52 0.31 -0.28

40-20-40 Managed Futures Portfolio 4/1/2007 -19.71 N/A -0.18

40-20-40 Market Neutral Portfolio 10/1/2003 -9.39 0.67 0.32

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Biggest Obstacles to Alternatives becoming Mainstream

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Increased Importance of Alternative Investments

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 Convergence of Hedge Funds and Alternative Mutual Funds

× “Gartmore Group Ltd., a British manager of about 21.8 billion pounds

($36 billion) that announced plans for an initial public offering last
week, said it’s aiming for a ‘convergence’ of hedge-fund and mutual-
fund investments.” Bloomberg.com November 24th

× “Competition and Convergence: The Evolving Landscape for Hedge

Funds,” study commissioned by Pershing LLC May 2009
× “The projection of growth in equity long/short investing by
[traditional] investment managers shows the sector reaching
$345 billion in assets by 2012, up from $204 billion today.”

× Hedge fund companies venturing into mutual fund land:

× AQR, AlphaSimplex, Bull Path, Highbridge

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 Questions & Comments

× Nadia Papagiannis
× nadia.papagiannis@morningstar.com
× 312-384-4100
× Scott Burns, Director of Alternative Investments
× scott.burns@morningstar.com
× 312-696-6586

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