About five years ago, alternative mutual funds – aka “liquid alternatives” – exploded onto the investment stage.

For a time, the genre’s hottest category was multialternative, which grew from a new Morningstar category in 2011 to about 500 funds currently.

Read: The original alternative funds

The multialternative category comprises a variety of actively managed investment styles including global macro, multistrategy, strategic allocation, tactical allocation, and hedge fund replication.

What they have in common is the portfolio manager’s ability to aggressively mix asset classes – which can include high yield and emerging market bonds, commodities and currencies – in search of timely opportunities and superior returns. (See Morningstar’s category description.)

Unfortunately, the category has not yet lived up to its potential.

For the three-years ending 4/21/16, Morningstar’s multialternative category returned an annualized 0.98 percent, well below the performance of all U.S. equity fund categories.

Read: Weak asset flows mark 2015

The category’s five-year annualized five-year performance was 1.55 percent, also below all U.S. equity fund categories. The past year has given multialternative funds a chance to prove their down-market mettle, but here, too, results were unimpressive – a category return of -4.96 percent, compared to -1.18 percent for Large Blend U.S. equities.

For all of these periods, multialternatives also underperformed Morningstar’s other large liquid-alternative category, Long/Short Equity.

Alternative mutual funds held total assets of $206 billion through the end of 2015, and their growth has been driven largely by financial advisors who believed in new categories like multialternative. Now, the space is littered with hundreds of relatively new and small multialternative funds with poor track records.

It will be difficult for many to claw out of the performance hole. If they don’t survive, financial advisors will be left trying to explain to clients what went wrong.

Actually, most of what went wrong might have been anticipated.

First, there are periods in which most active managers struggle to beat passive benchmarks, and the environment of the last few years, dominated by central bank influence, has been one of them.

Secondly, the performance of multialternatives has been hurt over time by high expense ratios and portfolio turnover, which average 1.65 percent and 208 percent, respectively, according to Morningstar.

Third, many managers of these funds did not have long tenures working in the same strategy. Morningstar lists only two multialternative funds with 10 years or more of manager tenure and 10 funds with five years or more of manager tenure.

Finally, asset size matters. Although there are hundreds of multialternative funds with less than $100 million in assets, only two of them are Morningstar five-star funds.

It’s important for advisors to consider a new mutual fund category’s track record. Then, it’s a good idea to screen the category for funds meeting manager tenure, cost-efficiency, and asset size thresholds.

If you search Morningstar’s data base for multialternative funds with five years or more of manager tenure, five-year performance better than the S&P 500’s, a cost ratio below 1.50 percent, and assets of $500 million or more, you will be left with just two choices, among about 500 funds.

In summary: Multialternatives have demonstrated why you should expect new fund categories to prove themselves over time – before putting your reputation on the line behind them.

Instant Insights /

What you can learn from multialternative mutual funds

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