| NEW YORK, April 23
NEW YORK, April 23 Ever since they were badly
burned in the 2008-2009 stock and bond debacle, investors have
been pouring money into so-called "alternative" mutual funds,
often at the behest of financial advisers who say those funds
will protect them from the fire next time.
But it is too soon to tell whether most of these funds will
work as suggested. Regulators, including the U.S. Securities and
Exchange Commission and the Financial Industry Regulatory
Authority, have expressed concerns about the risks inherent in
the more complex alternatives funds. And a sizeable number of
the investors buying these funds likely do not understand
exactly what they are buying.
There is good reason for their lack of clarity.
"Alternatives" are a catch-all category that can include
everything from real estate partnerships to mutual funds that
mimic hedge funds or use arcane hedging strategies. Most
typically they are the latter; advisers promote these funds as
vehicles that can reduce risk and goose returns.
Investors are buying the arguments, and the funds. In 2013
alone, they put $90 billion in net new money into alternatives,
reports Lipper. This year, they continue to add money at a rate
of more than $2 billion a month, Morningstar said.
With new money piling in and markets rising, "assets could
grow 40 percent in 2014," said Andrew Clark, an alternatives
analyst at Lipper. The funds in this category ended 2013 with
$282 billion in assets, up 65 percent in one year, he said. And
between the end of 2009 and the end of 2013, the number of
distinct alternatives funds (counting multiple share classes of
a fund as one fund) grew from 122 to 303.
Alternatives are controversial. There is a sizeable group of
fee-only financial advisers (those who do not receive
commissions to sell products) who stay away from them
altogether. For example, Susan Elswer, an Indianapolis adviser,
and Christopher VanSlyke, from Austin, both said they avoid
these funds because they carry high fees and tend not to be
transparent enough. Both said they use low-cost, short-term
high-quality bond funds to reduce risk.
But a notable minority say they do recommend alternatives.
Roman Franklin, a Deland, Florida adviser who is also fee-only
and, therefore, not compensated in any additional way for
recommending alternatives, says "I feel like this is one of the
ways we could add value, if we could come up with a good due
diligence research process."
That process can be challenging, according to Morningstar's
alternatives analyst, Josh Charlson. That is because the vast
majority of these funds sprung up in the aftermath of the
2008-2009 selloff and don't have enough of a performance history
for us to judge how they actually would perform during bad
times. They certainly have underperformed the runaway U.S. stock
market in 2013, but they are not meant to beat stocks, they are
meant to cushion bear markets or squeeze better-than-bond
returns out of income investments.
So, without those long performance histories, how should you
evaluate an alternative recommendation? Here are some questions
to ask your adviser.
- Why? Why is this fund being suggested? Is it to calm your
portfolio during bad times or to add extra income? The kinds of
funds used for one are not the kinds used for another. In the
last year, the most popular alternatives have been bond
alternative funds, which allow managers to invest in foreign
bonds and low-rated bonds and derivatives and other products to
win bigger returns than low-interest rate bonds.
- How? How will the fund accomplish its stated goal? Require
your adviser to explain the strategy to you well enough so that
you understand it. For example, many of these funds employ
long/short strategies. They buy shares of companies that they
expect to grow, and then short (borrow shares to sell) shares of
competitive firms or broader indexes at the same time. A trade
like that can eliminate or reduce the risk that the whole market
will drop, while giving you the upside on the stocks purchased -
the "long" stocks. Ask: How did that strategy perform in 2008
- Who? If you're being sold an alternatives fund that has
only been around for a year or two, find out who the manager is
and what she or he did before. Perhaps they ran a hedge fund.
How did it do in 2008 and 2009? What kind of reputation and
performance history does the fund company have?
- How much? Alternative funds can be expensive. The average
investor would pay 1.88 percent a year in expenses, according to
Morningstar. You can buy a risk-mitigating short-term bond index
fund for around 0.20 percent a year and a return-boosting stock
dividend fund for roughly 0.3 percent a year. They aren't
directly comparable, of course, but it's worth asking how much
more you'll get for your money. And, if you are working with an
adviser who earns commissions for selling products, ask
directly: How much will you earn by selling me this alternatives
fund, compared with something more traditional and less
(Linda Stern is a Reuters columnist. The opinions expressed are
her own. The Stern Advice column appears weekly, and at
additional times as warranted. Linda Stern can be reached at
firstname.lastname@example.org; She tweets at www.twitter.com/lindastern
.; Read more of her work at blogs.reuters.com/linda-stern;
Editing by Paul Simao)