NEW YORK (Reuters) - 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 and 2009?
- 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 expensive?
Linda Stern is a Reuters columnist. The opinions expressed are her own. Editing by Paul Simao