Mutual funds that use hedge-fund strategies aim for a smoother ride; they're getting tested

Economic Indicators Associated Press

Hedge funds aren't just for the 1 percent. The mutual-fund industry wants average investors to get into its own version of hedge funds, saying they can offer protection when the stock market is tumbling. Kind of like it has been doing the last few weeks.

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The industry's push has helped draw more than $10 billion in investment to these "hedge funds for the masses" over the last year, and they're now in the midst of a stress test. These funds, also called liquid alternative funds, are supposed to deftly maneuver rocky markets thanks to the more complicated strategies they use. So, did they do that this past month, when the Standard & Poor's 500 index had its first correction since 2011?

Yes, depending on your expectations. Alternative funds lost money, but not as much as traditional stock funds. That cushioned blow may be attractive to investors looking for a steadier ride than stocks. But it's important to keep in mind that these funds come with their own risks and drawbacks, with a high price tag chief among them.

Here's a look at what liquid alternative funds do and how they've performed.

WHAT THEY ARE

Hedge funds have long been open only to big institutional investors, such as pension funds and endowments, and wealthy families. Deep-pocketed investors have historically bought into hedge funds because of the different trading strategies they use.

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Instead of simply looking for a stock to rise in price, for example, hedge funds also make money from falling stocks by selling them short. In such trades, they borrow shares, sell them and buy them back later at a lower price.

Other hedge funds buy bonds of companies in or expected to soon enter bankruptcy, which traditional mutual funds avoid. Hedge funds also scour the commodity, foreign-currency and other global markets in search of opportunities.

The mutual-fund industry has taken many of these strategies and packaged them in funds targeting average investors, requiring as little as $1,000 to enter.

Such funds can go by many names depending on which strategies they use. Long-short funds, for example, sell some stocks short and buy others on expectations they'll rise. Multi-alternative funds have a mix of different hedge-fund strategies.

WHAT THEY'RE SUPPOSED TO DO

Alternative funds hope to make a portfolio more diverse, by complementing traditional stock and bond funds, and helping to steady performance.

"We're aiming for returns that are between fixed income and stocks," says Ken LaPlace. He's a managing director at Rock Creek Group and helps run the Wells Fargo Advantage Alternative Strategies fund.

Traditionally, investors worried about the potentially big swings in the stock market turned to bonds to steady their portfolios. High-quality bonds returned 5.2 percent in 2008, for example, when the financial crisis dragged the S&P 500 to a 37 percent loss.

But a decades-long drop in yields means bonds offer less income than before, muting expectations for future returns. "Fixed income is not going to make a return for the next 10 years that it did for the last 10 years," LaPlace says, "and people are looking for an alternative to that."

His fund has made money this year despite all the market's volatility, but LaPlace cautions that his and other alternative funds aren't infallible. Many alternative funds aim just to give a smoother ride than the stock market, not to make money in every type of market.

HOW THEY'VE PERFORMED

The sell-off that hit global markets during August hurt alternative funds too. Consider multi-alternative funds, which attracted more dollars in the last year than any other type of alternative fund. They lost an average of 2.3 percent in August, according to Morningstar.

Although that hurts, it's not as painful as the 6.1 percent loss for the largest category of traditional stock funds. The trend has held during other down months for stocks, which means hedge funds for the masses have at least partially shielded their investors this year.

Multi-alternative funds are down an average of 1.6 percent for the year through Wednesday. The largest category of traditional stock funds has lost more than triple that, 4.9 percent.

Over the longer term, though, the comparison isn't so attractive. While alternative funds can limit losses during down markets, they also lag when the market is rising. And stocks have been on a nearly nonstop rise since bottoming in March 2009. The average multi-alternative fund has returned an annualized 3.1 percent over the last five years, well below the 12.9 percent average for large-cap blend stock funds.

THEIR DRAWBACKS

Alternative mutual funds are cheap when compared against hedge funds, but they're much more expensive than traditional mutual funds. That means managers have a higher hurdle to jump to get to positive returns.

Many alternative mutual funds have expense ratios above 2 percent, which means they keep $20 annually of every $1,000 invested in the fund to pay expenses.

The biggest stock mutual fund by assets, Vanguard's Total Stock Market Index fund, keeps $1.70 of every $1,000 invested. As an index fund, it has particularly low expenses, but even funds run by stock pickers charge less. Actively managed stock funds kept $8.60 of every $1,000 invested last year, according to the Investment Company Institute.

The recent proliferation of alternative mutual funds also means that many are too young to have a long track record. That can make it tough to feel comfortable paying such high fees, particularly when the trading strategies they use can be difficult for lay investors to understand.

Hedge funds have a longer track record but have been up and down as a group in recent years. An index of hedge-fund performance fell by about half as much as the S&P 500 in 2008, for example, but it had weaker returns than both stock and bond indexes last year, according to Hedge Fund Research.