Can alternatives protect against falling markets?
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Christine St Anne is Morningtar's online editor.
Downside protection is a market term used to describe strategies that protect investors from falling markets by minimising potential losses.
Alternative investment funds use a number of strategies that give investors this downside protection. These strategies aim to generate returns that have a low correlation to traditional asset classes.
They also aim to generate what are called "absolute returns," meaning positive returns in all market conditions.
Morningstar's recent review of alternative investments describes these strategies as those that invest in mainstream asset classes such as equities, bonds, property and cash, as well as other instruments such as currencies and commodities.
Fund managers that manage alternative strategies also use derivatives to take both long and short positions and sometimes use more esoteric and less liquid investments such as leveraged loans, micro-caps, and frontier markets, as well as leverage.
Hedge funds are one example of an alternative investment strategy. Other examples include managed futures, which as the name suggests, primarily use futures contracts to implement their positions. These funds include the AQR Managed Futures Fund  and Winton Global Alpha .
Morningstar's review also included an analysis of absolute return/equity bias, long/short tactical and aggressive asset allocators. Examples of these strategies include the Certitude Asian Opportunities Fund  and the K2 Select International Absolute Return Fund .
These funds tend to allocate between equities and fixed interest/cash and use fundamentally based security selection.
These funds exploit perceived inefficiencies and mispricing in markets by using long/short strategies across a range of asset classes, including equities, fixed interest, currencies and commodities.
Dancing to the tune of the market
Morningstar's report looked at the performance of 14 funds in the sector over eight quarters to June 2012.
As noted earlier, these alternative strategies are supposed to be uncorrelated to traditional asset classes such as equities.
"While there was some degree of protection against market downturn, many of these strategies danced to the tune of the market," Morningstar senior research analyst Julian Robertson says.
Managed futures, and in some cases macro strategies, did perform in down markets. In particular, Morningstar's analysis found managed futures performed well in 2008 and continued to do so until very recently.