The rise of hedge funds in last decade's two bear markets have prompted mutual fund firms to launch products that mimic hedge fund strategies.
“There’s been hundreds of alternative mutual funds launched by traditional mutual fund companies, new mutual fund companies and even hedge funds. They are looking for new ways to solve investors’ needs and meet the demand for risk management, additional sources of return and tools to build more diversified portfolios,” said Rick Lake, co-chairman and treasurer of the Stamford, Conn.-based Lake Partners, a subadvisor for the Aston Funds.
According to Morningstar, in 2007 there were 112 alternative mutual funds available to advisors and investors, compared with 357 through December 11, 2012. Well over half -- 207 of them -- were created post-2008.
“They make sense for advisor clients because the primary purpose of these hedged mutual funds is to diversify a traditional portfolio and improve its risk return. A lower correlation to stocks and bonds, .6 or less, combined with a positive return will improve the overall risk return of an investor’s portfolio,” said Nadia Papagiannis, analyst and director of alternative fund research at Morningstar.
Understanding Financial Advisor Usage & Attitudes Toward Alternative Investments, an 2012 alternative investment trends study by Cogent Research, found that nearly three quarters of advisors currently use alternatives. About 47 percent use alternative investments to add diversification compared with 25 percent who used them for downside protection and 13 percent for absolute return.
“Alternative mutual funds are capable and helpful diversifiers in an equity-oriented portfolio. They provide an opportunity to dampen volatility,” said Phil Wagner, a financial advisor and portfolio manager in the wealth management division of Bryn Mawr Trust, with $6 billion in assets under management. ”Alternative mutual funds can generate short-term capital gains. As a result, holding them in a tax-sheltered investment, such as a client’s IRA, can preserve the return benefits.”
About $13.9 billion dollars were invested into alternative mutual funds this year through October 31, according to Morningstar. While, alternative currency mutual funds yielded 3.29 percent year to date through December 11, long short equity alternative mutual funds returned 4.53 percent, compared with -7.83 for managed futures, 0.64 percent for market neutral alternative mutual funds and 3.67 percent for multi-alternative mutual funds.
Wagner advises using alternative or hedged mutual funds as a buffer over fixed-income investments because low yields mean high bond prices.
“In this interest rate environment, when including fixed-income investments as an equity diversifier, you may be adding risk to the portfolio. Alternative mutual funds can diversify without the interest-rate risk that‘s embedded in fixed-income investments,” Wagner said.
Alternative mutual fund fees are lower than traditional hedge funds but higher than equity mutual funds. Many hedge funds charge 20 percent of any profits plus a 2 percent management fee. Hedged or alternative mutual funds fees can be as high as 2 percent of assets compared to an average of 1 percent for a stock fund and 0.5 percent for a bond fund, according to John Longo, a registered investment advisor in Morristown, N.J.
"Hedged mutual funds can both reduce losses or make money. They are designed to return a small amount in any market. On balance, they add choice and selection to a client's menu," Longo said.
Further enhancing competition in the alternative mutual fund space is the recent U.S. Securities and Exchange Commission’s announcement that it was partially lifting its ban on derivatives.
“Most of the alternative mutual funds on the market today use derivatives as a hedging tool primarily. As a result of the ban being lifted, we will see more ETF alternative mutual funds in the future,” Papagiannis said. “ETFs are a lower cost vehicle so there will be more price competition there for mutual fund firms offering alternative mutual funds.”
Characteristics of alternative investment strategies include some mix of shorting or hedging, the inclusion of futures or derivatives, or non-standard techniques such as illiquid securities and leverage, which are limited under mutual fund regulation.
“Liquid alternatives or alternative mutual funds provide access to alternative strategies with greater investor protection because registered investment companies are highly regulated. For example, investor assets must be held in a segregated and protected fashion,” said Lake. “Daily liquidity is a mandate so there’s strict limitations on illiquid securities and leverage. Finally, regulation makes it difficult for a manager to charge a hedge fund style incentive fee so alternative mutual funds are also low cost.”