Investing in Alternative Funds

In these tough times, investors want alternatives to traditional asset classes that are now so disappointing -- investments that will zig while everything else is zagging.

``Alternative'' funds aim to deliver consistently positive returns by eliminating or substantially reducing market risk. It's such a compelling pitch for investors seeking havens from recent market volatility that Lipper, a Thomson Reuters company, says assets in these funds have grown almost 125 percent in the last three years to $531 billion.

``That's astounding, especially when you consider that $249 billion -- almost 85 percent of that growth -- is inflows from investors, not performance,'' says Matthew Lemieux, a Lipper research analyst. The number of alternative mutual funds and ETFs has doubled since the end of 2008, to 289 and 427 respectively, Morningstar, another fund tracker, says.

Clearly, alternatives are hot. But what exactly are they? If you don't know, you have plenty of company. A recent survey of investors by Natixis Global Asset Management found 70 percent understood alternatives ``only a little'' or ``not well at all.'' More than two out of five had no idea what alternatives are.

Your adviser may not know, either. In a recent InvestmentNews survey, 52 percent of financial advisers said they don't feel as knowledgeable about alternatives as they'd like to be -- yet 88 percent are using them in client portfolios.

So, what is an alternative asset? It's anything that isn't a stock, bond or cash, which means that real estate, gold and commodities are all alternatives. When you buy an ``alternative'' mutual fund, you're not actually buying an asset class, but rather a strategy -- in fact, multiple strategies that are typically used by hedge funds.

These funds invest in a broad range of asset classes and derivatives (financial contracts whose value is based on the value of other instruments, such as stocks, bonds, currencies, or market indexes). And they don't just buy assets they like; they also bet against those they think will perform poorly with short sales.

Morningstar has grouped alternative mutual funds into six categories: Currency, Market Neutral, Multialternative, Managed Futures, Long/Short Equity, and Bear Market.

A few things to consider before opting for alternatives:

1. Do I understand what the fund does?

Alternative strategies can be mind-numbingly complex. It takes an experienced adviser to research and explain these investments and monitor them. So to delve into this, pick a fee-only adviser, not one who earns commissions for selling it. Fund managers can change strategies at will, so unless you actively monitor a fund, you may not know what you own, says Ross Levin, president of Accredited Investors, an Edina, Minnesota wealth management firm.

2. Do I trust the fund managers?

You're buying the judgment of the people running the fund far more than in a traditional fund. ``Don't just look for a good story, look at the people telling it,'' advises Harold Evensky, president of Evensky & Katz, a Coral Gables, Florida wealth manager. Or as Levin puts it: ``If I invest with Warren Buffett, I don't know what he's going to buy, but I know I like his approach, how he thinks. The same is true when I buy an alternative fund.''

Most hedge fund strategies are ill-suited to the retail market, says Eleanor Blayney, a McLean, Virginia adviser who is consumer advocate for the Certified Financial Planner Board of Standards. ``It troubles me that you're not just picking a strategy, you're choosing the genius behind it. How good will you be at choosing a genius?''

The recent track records of Wall Street geniuses may give you pause.

3. What's the cost?

These funds are expensive. Morningstar's average expense ratios for the group range from 1.85 percent for multialternative funds to 2.30 percent for long/short equity funds. And they typically have high portfolio turnover, which means high trading costs and short-term capital gains taxes for shareholders.

4. How can I reasonably expect them to perform?

That's hard to say. Most alternative funds have short track records, and few have benchmarks in the traditional sense. Their goal typically is ``absolute return,'' a positive return regardless of market direction. (By contrast, traditional funds seek good returns relative to the market.)

As a group, the performance of these funds has been spotty at best. In 2008, a traditional 60/40 portfolio lost 21.63 percent of its value; two of Morningstar's six alternative categories (bear market funds and managed futures funds) had positive returns, earning 29.95 percent and 8.33 percent respectively.

The other four categories sustained losses ranging from a loss of 22.14 percent for multialternative funds to a loss of 0.33 percent for market neutral funds. In 2009, the market recovered, and a 60/40 portfolio returned 18.46 percent. Five of the six alternative categories sustained losses ranging from a decline of 33.88 percent in bear market funds to a loss of 1.18 percent for market neutral funds. One (long/short funds) had a positive return, earning 10.46 percent.

Long-term returns will probably lag the market. ``Anything that does well in a bear market almost by definition has to have low long-term returns,'' says William Bernstein, a principal in Efficient Frontier Advisors, an Eastford, Connecticut wealth manager.

5. How do they fit in my portfolio?

Alternative funds are intended to work with traditional funds, not replace them. For example, Evensky says of the investment strategy at his firm: ``We've allocated 8 percent of our portfolios to alternatives: 4 percent from fixed-income and 4 percent from equities. They don't affect our overall long-term return expectations because we believe their returns will fall somewhere between bonds and stocks.''

Don't invest in alternatives for good performance, Levin adds. The reason to own them is to mitigate risk. You can accomplish the same thing with a cash allocation without sacrificing significant return, he says. ``For most people that makes more sense than adding a category that's hard to understand, hard to manage, and can change radically with the manager's strategy.''

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The author is a Reuters contributor. The opinions expressed are her own. (Editing by Jilian Mincer and Beth Gladstone)