April 11, 2013
Flows into “alternative” mutual funds have increased dramatically since the financial crisis as retail investors search for ways to diversify their portfolios and protect themselves against down markets. While alternative mutual funds comprise slightly less than 1 per cent of total mutual fund assets, Morningstar data show investors have added billions to their coffers since 2007 when they held $37.6bn. Since then, assets have more than doubled to about $90.7bn last year.
Some advisers warn that such funds are not appropriate for everyone and suggest that those who are interested pursue in-depth discussions before making an allocation. For investors new to alternatives, experts suggest keeping allocations small, creating a diversified portfolio and avoiding “trendy” products.
“Alternatives are kind of a sexy thing to talk about. People read about them and wonder, ‘Why aren’t I doing this?'” says Stephen Fish, senior vice-president at Hilliard Lyons in Kenwood, Ohio. “The growing popularity of retail alternatives is absolutely true. But a lot of that is [because of the] popular press, where financial consultants want to appear to be at the top of their game … investors should have a financial consultant who knows enough to have a conversation and who is able to say to certain investors: ‘This is not appropriate for you.'”
Alternative mutual funds aim to emulate some of the strategies only available to extremely wealthy people and institutional investors that can post very large minimums. Many advisers define “alternatives” as anything other than long-only stocks, bonds or cash, meaning that, when they are discussing an “alternative fund”, they could mean funds focused on private equity, hedge fund strategies, commodities, currencies or other investment types.
Regulations restrict mutual funds’ use of illiquid assets and leverage, so some alternative strategies cannot be duplicated. But the transparency and daily liquidity available in an alternative mutual fund can trump other concerns, especially for wealthy individuals.
Alternative retail funds are not appropriate for every retail investor and certain investors should avoid the asset class entirely, some say. Investors who want their entire portfolio to create income because their capital is deteriorating, for example, might not want any alternative funds, Mr Fish argues. Nor should investors feel uncomfortable, other advisers say, with an allocation that appears to perform poorly during certain markets while the rest of their portfolio performs well.
Some are more enthusiastic than others, while certain advisers have stricter guidelines. Investors could approach the topic by first asking how their advisers define “alternative” and what function an alternative allocation would fulfil in a portfolio, experts suggest.
“It’s a very expansive category,” says Brad Wheelock, senior vice-president at RBC Wealth Management of St Cloud, Minnesota. “Investors first need to understand: is it an inflation hedge? Protection of principal in a downward market? What’s the overall goal? Once that’s established, we would want to construct a portfolio that encompasses a lot of scenarios.”
Mr Wheelock urges caution because, in some cases, alternatives can “look wonderful in concept, and they’re supported by academic opinion, but in a pragmatic sense don’t work”.
The asset allocation should be targeted at investors’ goals, needs and appetite for risk, experts say.
Ben Marks, president and chief investment officer at Marks Group Wealth Management in Minnetonka, Minnesota, says investors should “start with a discipline, choose a percentage, make a decision based on tolerance to risk and other investment objectives” and avoid decisions based on short-term expectations.
As investors’ allocation to alternatives comes into sharper focus, they should narrow the scope of their questions, asking how well the asset classes being considered perform during typical markets, as well as during the difficult ones, says Debra Brede, founder of DK Brede Investment Management, based in Needham, Massachusetts.
Experts suggest investors need to make sure they know how expensive their new portfolio will be and whether the projected returns or risk mitigation justify the expense.
Derivatives and other alternative products and strategies are costly, making alternative mutual funds significantly more expensive than the more traditional mutual funds.
“Alternative investments in their various forms are typically more profitable to mutual fund companies and investment firms … investors should evaluate them cautiously,” Mr Wheelock says.
“Not to say they’re all wrong but any time something is extraordinarily beneficial to one party, you want to make sure it’s equally productive for the other party.”