Liquid Alternatives Challenges and Opportunities...• Macro investing struggles • Illiquidity and credit concerns Name Morningstar Analyst Rating 3-Year Ann. Return AQR Style Premia

©2018 Morningstar, Inc. All rights reserved.

Tayfun Icten Multi-Asset and Alternative Strategies

28 February 2018

Liquid Alternatives – Challenges and Opportunities

Rates Matter for Alternatives

Hedge Fund Index Returns vs. U.S. 10-Year Yield (15-Year Window)

2

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

12

/1/2

00

3

4/1

/20

04

8/1

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04

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/1/2

00

4

4/1

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12

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00

6

4/1

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8/1

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12

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00

7

4/1

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08

8/1

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08

12

/1/2

00

8

4/1

/20

09

8/1

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09

12

/1/2

00

9

4/1

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10

8/1

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10

12

/1/2

01

0

4/1

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11

8/1

/20

11

12

/1/2

01

1

4/1

/20

12

8/1

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12

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2

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13

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3

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12

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15

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12

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5

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16

8/1

/20

16

12

/1/2

01

6

4/1

/20

17

8/1

/20

17

HF Return - Left Axis 10-Year Yield - Right Axis

Source: Morningstar Source: Morningstar, Inc.

3

Long-Term Returns Have Eroded

60/40 Portfolio vs. Credit Suisse Hedge Fund Index

0%

2%

4%

6%

8%

10%

12%

14%

12

/20

03

4/2

00

4

8/2

00

4

12

/20

04

4/2

00

5

8/2

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5

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6

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0

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0

12

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10

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1

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1

12

/20

11

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2

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2

12

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5

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6

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6

12

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16

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01

7

8/2

01

7

HF 10 YR Roll 60/40 10 YR Rolling ReturnSource: Morningstar, Inc.

4

Liquid Alternative Mutual Funds Continue to Grow

Despite the weakness in long-term returns, liquid alts have experienced reasonable growth.

0

50,000,000,000

100,000,000,000

150,000,000,000

200,000,000,000

250,000,000,000

Total Net Assets

$ Billions

Source: Morningstar, Inc.

5

Some Alternatives Have Grown Faster Than Others

Asset Growth by Morningstar Category

0

10,000,000,000

20,000,000,000

30,000,000,000

40,000,000,000

50,000,000,000

60,000,000,000

Long Short Credit

Long Short Equity

Managed Futures

Market Neutral

Multialternative

Multicurrency

Options-Based

$ Billions


6

Some Alternatives Categories Are Seeing Outflows

Estimated net flows, organic growth, and total assets as of January 2018.

Morningstar Category 1-Mo QTD YTD 1-Yr

Organic Growth Rate % (TTM)

Total Assets

($Bil)US Fund Multialternative 1,083 1,083 1,083 2,889 5.77 56 US Fund Long-Short Equity 992 992 992 2,942 8.84 41 US Fund Managed Futures (116) (116) (116) (2,162) (8.52) 25 US Fund Market Neutral 331 331 331 414 2.01 22 US Fund Options-Based 276 276 276 1,330 8.70 17 US Fund Long-Short Credit (8) (8) (8) (480) (6.26) 7 US Fund Multicurrency (14) (14) (14) 325 5.53 7

© Copyright 2018 Morningstar, Inc.

7

Performance Improves for Alts Categories in 2017, With Some Unexpected Results in 2018

Name 2017

Perf.

3 Year

Ann.

5 year

Ann.

5-Year

Beta to

60/40

5 Year

Beta to

SPX

Recent

Sell-Off

Jan 26th

to Feb 8

5-year

Sharpe

25-Year

Sharpe

60% AGG - 40% VTI 10.4% 6.2% 7.3% 1.00 0.40 -4.8% 1.63

US Fund Long-Short Equity 11.2% 5.8% 6.2% 1.02 0.51 -6.3% 1.04 0.53

US Fund Options-Based 9.1% 5.4% 5.2% 0.88 0.42 -8.1% 1.21 0.50

US Fund Multialternative 5.1% 2.0% 2.6% 0.66 0.27 -4.0% 0.50

US Fund Managed Futures 3.0% 0.1% 3.8% 0.34 0.05 -8.6% 0.25

US Fund Long-Short Credit 2.4% 1.7% 1.5% 0.38 0.14 -0.9% 0.44

US Fund Market Neutral 2.4% 1.1% 1.2% 0.18 0.09 -1.4% 0.99 0.27

US Fund Multicurrency 0.8% 0.5% -0.5% 0.32 0.11 -0.4% -0.09 -0.10

SPDR® S&P 500 ETF 21.7% 14.5% 15.8% 2.03 1.00 -10.1% 1.56 0.55

Average Beta 0.54 0.23


8

Alternatives Provided Some Downside Protection From Peak to Trough

Alts category returns versus major asset-class performance

Name Recent Market

Turbulence from

Jan 26 to Feb 8

CBOE Market Volatility (VIX) 201.44

US Dollar 1.3%

US Fund Multicurrency -0.4%

iShares 3-7 Year Treasury Bond ETF -0.4%

US Fund Long-Short Credit -0.9%

BBgBarc US Agg Bond TR USD -1.0%

US Fund Market Neutral -1.4%

BBgBarc High Yield Corporate TR USD -1.4%

SPDR® Gold Shares -2.8%

US Fund Multialternative -4.0%

US Fund Long-Short Equity -6.3%

United States Oil -7.5%

US Fund Options-based -8.1%

US Fund Managed Futures -8.6%

iShares MSCI Emerging Markets ETF -8.6%

iShares Edge MSCI Min Vol USA ETF -9.1%

S&P 500 TR USD -10.1%

NASDAQ 100 TR USD -10.2%

iShares Edge MSCI USA Value Factor ETF -10.2%

iShares Edge MSCI USA Momentum Fctr ETF -10.3%

SG Trend Index -11.9%

Average Alts Category Performance -4.2%Source: Morningstar, Inc.

9

Multialternative: Category Considerations and Medalist Performance

(3-Year period ending January 2018)

Category Considerations

• Roughly 0.3 average beta • Most heterogeneous • Global-macro return

drivers• Style-premium return

drivers• Other alternative betas • Asset-allocation models• Traditional fundamental

long-short • Hedge fund replication

products• Macro investing struggles• Illiquidity and credit

concerns

Name Morningstar Analyst Rating

3-Year Ann. Return

AQR Style Premia Alternative I Silver 7.6%

Goldman Sachs Absolute Ret Trckr Instl Bronze 4.6%AQR Style Premia Alternative LV R6 Silver 4.4%

Litman Gregory Masters Alt Strats Instl Bronze 3.6%AQR Multi-Strategy Alternative I Bronze 3.4%Principal Global Multi-Strategy Instl Bronze 3.2%WCM Alternatives Event-Driven Instl Bronze 2.5%GMO SGM Major Markets III Bronze 2.1%Dreyfus Global Real Return I Silver 1.7%

JHancock Global Absolute Ret Strats NAV Bronze 0.9%William Blair Macro Allocation I Bronze 0.5%

Multialternative Category Average 2.0%Morningstar Medalist Average 3.1%


10

Long-Short Equity: Category Considerations and Medalist Performance



• Average beta 0.5

• Pure company-specific risk

• Factor-based risk premia

• Risks other than single stock specific

• Often downside protection in mind

• Seek market dislocation


3-Year Ann.

Return

AQR Long-Short Equity I Bronze 15.72Boston Partners Long/Short Equity Instl Bronze 9.82

Schwab Hedged Equity Bronze 8.34

Diamond Hill Long-Short I Bronze 7.47

Boston Partners Long/Short Rsrch Instl Silver 7.24Boston Partners Global Long/Short Instl Bronze 6.38

Long-Short Equity Category Average 5.8%

Morningstar Medalist Average 9.2%


11

Market Neutral: Category Considerations and Medalist Performance



• Zero beta

• Factor long-short

• Merger spreads and deal volume

• Multiple dimensions in neutrality

• Low short rates are not good

• Subject to factor crash risk

• Leverage


3-year Ann.

ReturnAQR Equity Market Neutral I Bronze 9.4%AQR Diversified Arbitrage I Bronze 2.9%Touchstone Merger Arbitrage Instl Bronze 2.7%AC Alternatives® Market Neutral Val I Bronze 2.5%Arbitrage I Bronze 2.5%Merger Institutional Bronze 2.3%BlackRock Global Long/Short Equity Instl Bronze 1.3%Vanguard Market Neutral I Silver 1.2%

Market-Neutral Category Average 1.1%Morningstar Medalist Average 3.1%


Managed Futures: Category Considerations and Medalist Performance


12



3-Year Ann.

Return

American Beacon AHL Mgd Futs Strat Instl Bronze 2.2%

Credit Suisse Managed Futs Strat I Bronze 1.2%Natixis ASG Managed Futures Strategy Y Bronze -0.5%

Abbey Capital Futures Strategy I Bronze -0.5%

AQR Managed Futures Strategy I Bronze -2.8%

AQR Managed Futures Strategy HV I Bronze -4.9%

Managed-Futures Category Average 0.1%

Morningstar Medalist Average -0.9%


• Zero beta with some spikes

• Systematic trend-followers dominate

• Time series momentum

• Volatile periods and max drawdown

• Margined derivative accounts, but not short vega

• Not a 100% hedge

• Must understand margin/equity ratio

Options-Based: Category Considerations and Medalist Performance


13



• Market beta ranges from -0.5 to 1.0

• Systematic “outcome-based” strategies make up the core

• Consistent options-based strategies for qualification

• Very large dispersion year to date

• Watch for naked option sellers/tail risks!!!

• Look at daily returns!

• Similar to credit-sensitive bonds

• If you must, keep it small


3-year Ann. Return

JPMorgan Hedged Equity I Silver 7.7%

Gateway Y Silver 6.7%

Swan Defined Risk I Bronze 4.7%AllianzGI Structured Return P Bronze 4.5%

Options-Based Category Average 5.4%Morningstar Medalist Average 5.9%

Credit Long-Short and Multicurrency: Category Considerations

14


• No Morningstar Medalists here

• Duration-neutral portfolios, spread assets, and static hedges

• Compressed credit spreads, no external leverage

• Beware of derivatives and structured products’ internal leverage

• After a major credit dislocation, these funds may provide better value

• Small doses to add cash plus yield, but tail risks may be hidden

• Highly heterogeneous

• The core is the “carry trade,” a global-macro risk factor

• Invest in higher-yielding currencies against the U.S. dollar

• High correlation to equities

• Other players may be net long or short the U.S. dollar

Credit Long-Short Strategy Multicurrency

Alternatives Charge More Than Double for Institutional Share Classes

15


Distribution Group - Alternatives

Calculated

Average Net

Expense Ratio

Distribution

Category

Median Distribution Group - Traditional

Calculated

Average Net

Expense Ratio

Distribution

Category

Median

Equity Alternative Defer Load 2.31 2.20 Small Cap Deferred Load 2.03 2.02

Equity Alternative Front Load 1.79 1.73 Small Cap Front Load 1.31 1.35

Equity Alternative Institutional 1.46 1.40 Small Cap Institutional 0.99 0.99

Equity Alternative Level Load 2.47 2.45 Small Cap Level Load 2.05 2.01

Equity Alternative No Load 1.61 1.50 Small Cap No Load 1.17 1.12

Equity Alternative Retirement, Large 1.18 1.25 Small Cap Retirement, Large 0.90 0.87

Equity Alternative Retirement, Medium 1.79 1.74 Small Cap Retirement, Medium 1.53 1.47

Equity Alternative Retirement, Small 2.20 2.20 Small Cap Retirement, Small 1.63 1.67

Managed Futures Defer Load 2.35 2.35 Intermediate-Term Bond Deferred Load 1.52 1.49

Managed Futures Front Load 2.04 1.94 Intermediate-Term Bond Front Load 0.83 0.85

Managed Futures Institutional 1.62 1.57 Intermediate-Term Bond Institutional 0.50 0.51

Managed Futures Level Load 2.66 2.69 Intermediate-Term Bond Level Load 1.53 1.49

Managed Futures No Load 1.86 1.91 Intermediate-Term Bond No Load 0.65 0.63

Managed Futures Retirement, Large 1.22 1.20 Intermediate-Term Bond Retirement, Large 0.48 0.49

Managed Futures Retirement, Medium 1.90 1.90 Intermediate-Term Bond Retirement, Medium 1.10 1.01

Multialternative Defer Load 2.07 2.08 Intermediate-Term Bond Retirement, Small 1.08 1.17

Multialternative Front Load 1.84 1.75 Large Cap Deferred Load 1.83 1.91

Multialternative Institutional 1.55 1.49 Large Cap Front Load 1.11 1.15

Multialternative Level Load 2.54 2.49 Large Cap Institutional 0.75 0.72

Multialternative No Load 1.73 1.60 Large Cap Level Load 1.89 1.78

Multialternative Retirement, Large 1.31 1.25 Large Cap No Load 0.90 0.87

Multialternative Retirement, Medium 1.87 1.72 Large Cap Retirement, Large 0.65 0.63

Multialternative Retirement, Small 2.24 2.24 Large Cap Retirement, Medium 1.32 1.22

Large Cap Retirement, Small 1.42 1.40

Institutional Average 1.55 0.75

Front Load (Class A) 1.89 1.08

Level Load (Class C) 2.56 1.82

Morningstar Fee Study Results—Alternatives’ Fund Fees Have Gone Up

16


Share-Class-Related Flows (All Mutual Funds)

Morningstar Direct Flows Data

17


All Share Class Types

Name 1-Yr (Mil)

Mkt Sh%

Jan 2018

Mkt Sh%

Jan 2017

Inst 328,669 33.14 31.49

Other 231,225 20.33 18.97

A (225,580) 13.35 15.41

No Load (133,216) 13.33 14.40

Retirement 170,098 7.12 5.90

Inv (28,249) 6.57 6.93

C (70,992) 2.55 3.28

Adv 3,133 1.29 1.33

S (7,154) 0.68 0.73

D (1,116) 0.43 0.36

N (1,362) 0.41 0.45

B 20,686 0.40 0.25

M (4,308) 0.35 0.42

Unclassified (312) 0.05 0.05

T (2,530) 0.00 0.02

© Copyright 2018 Morningstar, Inc.

Concluding Remarks

18


• Rates matter for alternatives.

• Lower yields on cash holdings (managed futures, merger-arbitrage, credit long-short).

• Compressed credit spreads, option premiums, and overall risk premiums.

• More dislocations and more opportunities for alternative funds?

• Capacity-related considerations.

• Consolidation is not good for alternatives.

• The battle of bots versus humans.

• Increasing quantitative equity investing, alternative data, natural language processing.

• Overcrowding effects, Quant Quake of August 2007.

• A mix of traditional versus quantitative?

• Options-based strategies are complex, perhaps some are too complex!!!

• Be wary of naked option sellers.

• Time to be mindful of stock and bond correlations as rising rates can destabilize certain markets. Some alternative strategies may help.

• And finally, most alternatives are still too expensive for what they deliver.

19

Disclosures

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This presentation is for investment professional use only.

The analyst identified on the cover page is employed by Morningstar Research Services LLC, a wholly-owned subsidiary of Morningstar, Inc.

The information, data, and opinions presented herein are provided solely for informational purposes and are not warranted to be correct, complete or accurate. The

opinions expressed within are given in good faith, are as of the date of the presentation, are not statements of fact, are subject to change and in certain instances are

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Morningstar’s Manager Research Group’s current expectations about future events and therefore involve unknown risks and uncertainties that may cause such

expectations not to occur or to differ significantly from what was expected. Analyst Ratings are not guarantees nor should they be viewed as an assessment of a

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Documents

Liquid Alternatives Challenges and Opportunities...• Macro investing struggles • Illiquidity and credit concerns Name Morningstar Analyst Rating 3-Year Ann. Return AQR Style Premia