The volatile markets remain alternative investments' best friend, as investors increasingly look for ways to hedge their bets against gut-wrenching price swings. Seventy eight new alternative-oriented mutual funds were rolled out last year, bringing the total number of such funds to 338 as of year-end 2011. And that number is expected to keep rising, according to industry observers.

Assets in alternative mutual funds leaped roughly 20% last year, to $122 billion, notes Nadia Papagiannis, Morningstar's alternative investment strategist. "Independent advisors have wholeheartedly embraced the alternative investments to stabilize and distinguish their business and to fulfill their fiduciary deities to look out for the best interests of their clients," she says.

And for some advisors, that means ditching long-held notions about portfolio construction. "The days of a 60-40 portfolio are no longer relevant," says Adam Patti, CEO of Index IQ, which has a family of hedge fund replication ETFs. "You need other asset classes to have a well-diversified portfolio, and alternative mutual funds and ETFs provide that."

Because of the emergence of new alternatives, investors should look at the track record and the transparency of each fund before investing, says Patti.

What are alternative investments? The consensus view holds they should have a low correlation to equity and fixed income, as well as employ both long and short strategies. This includes hedge funds or hedge-style alternative strategies such as long-short, event driven, market-neutral, global macro, merger and convertible arbitrage, relative value, directional/tactical, managed futures, short bias and options strategies.

The long-short equity funds are generally benchmarked against traditional equity indexes and nontraditional bond funds against traditional bond indexes, Papagiannis says.

She adds that one of the newer alternative categories--nontraditional bonds--captured a lot of investor interest. Morningstar launched this new bond category last year to find a home for funds that follow strategies that diverge in some way from the conventional bond-fund universe. In general, nontraditional bond funds aim to protect investors against rising bond yields while trying to generate alpha without the typical downside volatility associated with taking market risks. The two most prominent approaches in this category are unconstrained and absolute return strategies.

Papagiannis says the number of assets in the nontraditional bond category grew by 31% last year, to $38 billion. She adds that another popular alternative fund category was managed futures, where assets zoomed roughly 240%, to $3.4 billion, by year-end 2011.

"People started hearing about managed futures after 2008 and it can be looked on as the ultimate diversifying product," Papagiannis says. "It is not correlated to the stock or bond market and advisors are eating up the funds."

Todd Rosenbluth, an ETF analyst at S&P Capital IQ, agrees with the notion that the rise of alternatives provides security for investors fearful of the market.

"Since 2008, the best advisors and asset managers have looked to give people alternatives they can play in the marketplace without being at the mercy of the S&P 500," Rosenbluth says. "They are looking at other asset classes and part of the benefit is that some of these alternatives are relatively cheap and transparent."

As for the size of alternative allocations to client portfolios, Papagiannis and Patti agree at least 10% to 30% is desirable but that 10% is probably too low. "At least 20% is necessary to provide any edge, and some say you should have as much in alternatives as you have in equities, depending on the strategy," Patti says.


--Karen DeMasters