Mutual funds in the multialternative space are investing in hedge funds, giving mutual fund investors access to some of finance’s most noted––and well compensated––management teams. The potential appeal for investors is obvious, but should financial advisors use these funds in clients portfolios?

Morningstar’s multialternative fund category includes mutual funds of hedge funds, which hire established hedge fund managers to manage assets and establish separately managed accounts with each manager, and then pool the results into a single mutual fund. The mutual fund negotiates fees that are less than a hedge fund’s traditional 2 percent and 20 percent fee structure, but those fees are still substantial as investors pay management fees for both the mutual fund and the underlying hedge funds.

“With the multi manager the two fee layers have really eaten into returns,” says Mallory Harejs, a Morningstar alternative investments analyst.

But following the financial market crash five years ago, investors increasingly yearn for non-correlated alternative assets to help protect against future downturns. “Investors are clearly interested in using alternatives and advisors are contemplating how to integrate these products into client portfolios,” Harejs says.

Morningstar’s perspective on mutual funds of hedge funds is less than enthusiastic, though. “These funds have short track records, and high fees across the board,” says Harejs, who covers both the Hatteras Alpha Hedge Strategies (ALPHX) and the Van Eck Multi-Manager Alternatives fund (VMAAX) funds. She’s put a “negative” rating on the former and a “neutral” rating on the latter.

Hatteras has returned 3.21 percent year-to-date versus 6.76.74 percent for a 60/40 S&P 500/Barclays Aggregate. The fund has averaged 3.52 percent annually for the last three years, trailing the 60/40’s 11.52 percent and the Morningstar MSCI Composite AW (a hedge fund index) return of 5.72 percent. The fund has a negative alpha, a measure of excess return, of -1.61 percent versus the 60/40 portfolio and -0.67 percent versus the hedge fund index. Since these funds have varying risk exposures, looking at a risk adjusted performance measure against a common index is one useful way to compare track records.

The Van Eck fund is down -0.5544 percent year-to-date, and has returned 0.85 percent annually over the past three years, also lagging on both an absolute and risk-adjusted basis. Its alpha versus the 60/40 is -3.67 percent, and versus the HF index, -2.85 per-cent. (The 60/40 portfolio is not a perfect benchmark, but it does allow for consistency when comparing these funds and it’s similar to the overall portfolio many advisors use.)

Adding insult to injury to these funds, Harejs notes the Hatteras fund’s expense ratio of 3.49% and Van Eck’s expenses of 3.5 percent have eaten into their performance over the past few years.

Yearning For Volatility

Bob Worthington, president of Hatteras Funds, offers that diversified portfolios invested across asset classes do best in choppy and volatile markets. “We tend to do better in choppy and uneven markets than straight up bull markets like 2012-2013, which we know don't last forever,” he says.

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