They're hot, yet many investors have no idea what they do.
These mutual funds go by a few names, and it doesn't help that some are inscrutable like "liquid alts," but they generally fall under an umbrella known as alternative mutual funds. Managers of alternative funds pitch that they can offer smoother returns than traditional stock and bond funds because they have access to more trading tools and markets. And their popularity is surging, though they come with their own risks and generally higher fees.
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Investors plugged a net $35 billion into alternative mutual funds over the last 12 months, according to Morningstar. That's more than went into bond mutual funds and nearly as much as into diversified U.S. stock funds. The growth is more striking in percentage terms because many alternative funds are still relatively young and small. Over the last year, total assets of alternative funds have grown by 30 percent, not including investment gains.
But the spurt of money doesn't mean widespread acceptance. Mention alternative funds even to savvy investors like financial advisers, and the default response is often a shrug.
Matt Straut should know. He's a sales manager for Wells Fargo Funds Management, who is traveling around the country to talk with investment advisers about alternative funds. But instead of trying to make a sale, he's focused more on helping them understand just what alternative funds are and if their clients would want them.
"We're almost in education-only mode," he says. "We're not placing any gauge on sales" because many advisers are in such an early stage of getting familiar with alternative funds.
Here's a look at questions investors should ask as they consider whether alternative funds are for them:
— WHAT DO THEY DO?
Many alternative fund managers use tools that are typically the province of hedge funds.
Brian Singer, for example, invests in everything from stocks to bonds to currencies with his William Blair Macro Allocation fund (WMCNX). And he invests not only when he expects an investment to rise in price but also when he's forecasting a drop. He does that through short-selling.
Now, for example, he isn't excited about U.S. stocks, which are more expensive after nearly tripling since early 2009. But he believes some parts of the market are pricier than others, particularly small-cap growth stocks. Late last year, he positioned the fund to benefit from a drop in their share prices. But he also made a trade that would profit if another part of the market, large-cap value stocks, rises.
Singer also invests in bonds -- his fund is shorting many types of bonds -- and in currencies, which he sees as some of the most fertile ground available. He expects gains for the Indian rupee and Malaysian ringgit, and he has investments set up to profit if the Australian dollar falls.
— WHAT KINDS OF RETURNS DO THEY OFFER?
Alternative funds aren't supposed to match the stock market, says Will Kinlaw, head of portfolio and risk management research at State Street Global Exchange. Their main purpose is to offer diversification to investors -- something that can hold steady or rise when stock markets are falling.
"If stocks are a car, these products are like bikes," Kinlaw says. "A biker is never going to outrun a car on an open highway, but in a traffic jam, a bike can weave through and be more consistent in its speed."
Given that many alternative mutual funds are less than 5 years old, many don't yet have a track record to show how they perform during sharp down markets.
— WHAT ROLE SHOULD THEY PLAY IN A PORTFOLIO?
Managers of some of the largest pension funds and university endowments have been using alternative investments for years, but usually only in a supporting role.
The nation's largest public pension fund, the California Public Employees' Retirement System, has less than 2 percent of its total assets in hedge-fund strategies. Yale University's endowment, a famous advocate, has about 18 percent.
— WHAT ABOUT THE HIGH PRICE TAG?
Alternative mutual funds are cheaper than hedge funds, which can charge a 2 percent fee on assets and an additional 20 percent of profits.
But they're still more expensive than traditional mutual funds, and higher fees mean an immediate disadvantage that a fund must surmount through better performance. The average expense ratio for an alternative mutual fund is 1.84 percent. That means $184 of every $10,000 invested in the funds go toward covering operational expenses.
Across all stock mutual funds, investors incurred an average expense of $74 last year for every $10,000 invested. Actively managed stock funds have higher expense ratios than index funds, but they also tend to be cheaper than alternative funds.
— WHAT OTHER RISKS ARE THERE?
Officials at the Securities and Exchange Commission have voiced some concerns. Some alternative funds invest in narrow segments of the market where finding a buyer can be difficult during tumultuous markets. That could exacerbate losses. Other funds can use borrowed money to amplify returns, which can also accelerate losses.