Dollars are pouring into alternative mutual funds, but make sure you know what you're getting

For most of us, investments fall into two simple categories: stocks or bonds.

Some investors are adding an "other" category in their search for possibly safer or better returns. They're pouring into what the industry calls alternative funds, which are generally bringing hedge-fund-like strategies to the masses. It's still a niche corner of the market, but nearly $13 billion flowed into alternative funds over the last year, according to Morningstar.

Still, there's confusion about what these funds do and whether they're worth the costs they charge over more straightforward index funds. The Gateway fund is one of the largest and oldest alternative funds in the market. Managers Mike Buckius and Paul Stewart recently discussed their fund's strategy. They invest in stocks, like a traditional stock fund, but they also buy and sell options, which they use to steady returns. Answers have been edited for clarity and length.

Q: What's the broad objective of the fund?

Buckius: We own stocks because they go up most of the time, and we do some things on the management side to smooth the ride out. We're trying to get a decent amount of the return with a lot less of the risk. That means we have smaller losses in downturns and shorter recovery periods. In bull markets, we tend to lag, but we still have positive returns.

Q: You've historically generated about two thirds of the S&P 500's returns, but with milder swings. Wouldn't a diversified portfolio, in which bonds balance out the risk of stocks, be similar?

Stewart: The thing is that the 10-year Treasury yield is hovering around 2 percent (about half what it was a decade ago). It's very difficult, nearly impossible, for the bond market to replicate the returns they had over the last 10 years.

Buckius: We're not investing in bonds, but the problem we're trying to address is: How do I manage the risk of my equity portfolio the way bonds have historically done?

Q: So the people coming into your fund are moving money that had been in bonds? Or are they selling stocks instead?

Buckius: I think a little bit of each. People in our fund are a little more on the conservative side, or they're older and they don't have the time to accept a three-, five- or seven-year time horizon to recover their losses from a bear market.

Q: Is there a wrong reason to get into a fund like yours?

Buckius: If you think a market crash is coming. We're there to cushion that, but we're not betting against the market. We expect the market to go up over a long period of time. We just don't want to ride the roller coaster.

Q: So much focus recently has been on keeping fees low. Your fees are maybe triple what an S&P 500 index fund charges.

Stewart: Yes, it's more expensive than an index fund. There's no denying that. But I would submit we're doing a lot more work than an index manager.

Q: When you talk with prospective investors, where do fees rank in the order of questions?

Stewart: Certainly not first. Maybe third or below that. People are interested in understanding the process and trying to understand where the returns are coming from.

Q: What kinds of markets are best for your fund? When there's a lot of volatility, because that increases the price for the options that you're selling and means more income for you?

Stewart: If we can get upward trending markets with high volatility buried within them, that's a great environment. The first quarter of this year was a good one: The S&P 500 was up 0.95 percent, and the Y-share class of our fund was up 1.15 percent.

Q: But last year you fell short of both the S&P 500 and general bond indexes.

Buckius: Last year, except at the end of the year, was a very low volatility year. That meant the income generated from what we do was just low.

Q: How much of a portfolio should be in alternatives?

Buckius: We see people having anywhere from 10 to 20 percent either in us or in a portfolio of two or three alternatives. The thought process behind that is you want to have enough to make a difference, but you still want to have exposure to traditional asset classes. A more aggressive portfolio may have 10 percent in alternatives, while a more conservative one may have as much as 40 percent.

Q: Was it difficult to convince your parents to invest in the fund?

Buckius: I think our parents probably fit the typical profile of someone who invests in us. It would be tougher to convince someone who's 20 years old and has all the time in the world until they retire. If they have 30 years or more, that's when they should be taking risks.