NEW YORK —
They're hot, yet many investors have no idea what they do.
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.
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.
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.
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
fund managers use tools that are typically the province of hedge
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
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,
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?
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.
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
— 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
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?
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.