Alternative funds have been one of the fastest-growing segments of the mutual fund industry in recent years. “Alt funds,” as they are commonly referred to, seek to provide attractive absolute and relative long-term returns, typically with lower risk than stock funds. They can offer diversification to traditional stock and bond portfolios.
When one considers the current rock-bottom bond yields, high stock valuations and the market’s recent volatility, it’s not difficult to understand alt funds’ appeal.
But some alternative mutual funds have fallen short. Their proliferation has increased the choices, making the research process even more important in selecting a solid fund for your clients.
For over a decade, our firm has invested in alternative strategies, including alternative mutual funds, for our clients. We have reviewed scores of these funds over that time period. Here are 10 rules to consider when researching them:
1. Begin With The End In Mind.
There are many varieties of alternative investment. The first step in evaluating an alternative mutual fund is determining what you are trying to accomplish. What level of risk, return and correlation to stock and bond markets are you looking for? Are you looking for a low-risk bond surrogate, a more growth-oriented (and thus riskier) strategy, or something in between? If you are adding alternatives to a traditional stock and bond portfolio, what asset classes are you reducing to make room for the new strategy? Knowing may help you determine the characteristics of the alternative investment you’re looking for. Alternative investment strategies sometimes promise to deliver “stock-like returns with bond-like risk,” but things that sound too good to be true usually are.
2. Don’t Skip The Basics.
Your research on alternative investments should include all of the due diligence you would normally conduct on traditional investment managers. That means evaluating a manager’s “four P’s”: its people, process, philosophy and performance. Quantitative data such as performance is available in mutual fund databases. The management firm’s investment presentation, shareholder reports and commentaries from recent years should offer insight on its people, investment process and philosophy. After you read these documents, a phone interview with the portfolio manager can help you understand his or her thinking. Finally, face time with key members of the investment team during on-site visits will be very useful in helping you assess the qualitative aspects of the manager.
3. More Complicated Strategies Take More Time To Research.
Alternative mutual funds are often more complicated than traditional stock and bond mutual funds. As fiduciaries, we are responsible for thoroughly investigating and researching the investments we recommend to our clients. For example, we followed managed futures strategies for years before investing in a fund for our clients. We wanted to take extra time to really understand how the investment worked. It should go without saying, but if you don’t have a good understanding of a strategy, you shouldn’t recommend it to your clients.
4. Ask What Could Go Wrong.
Risk is often thought of as volatility or the standard deviation of returns. When evaluating alternative investments, advisors should seek to gain a deeper understanding of the risks the strategy is taking and what could go wrong. We want to uncover hidden risks that may not show up in the investments’ historical standard deviation. The risk section of a fund’s prospectus can provide you with clues for investigating the risk of a strategy. For example, does the strategy employ leverage, use derivatives, invest in illiquid securities or use counterparties? What are the risks related to each? Other questions we often ask: What is a perfect storm for this strategy? How much could the strategy lose in that scenario? What risks does the portfolio manager believe are the most significant? In which environments is the strategy expected to do well—and in which will it likely do poorly?
5. Compare Apples To Apples.
It would be silly to compare a small-cap value fund with an emerging markets equity fund or compare a high-yield bond fund with a municipal bond fund. So it’s important to remember that alternatives also cover a wide range of similarly diverse strategies. Morningstar currently breaks the alternative universe into more than a dozen categories including long/short equity, bear market funds and market neutral funds. When researching alt funds, it’s important to compare those that follow similar strategies. Even within categories, the strategies can vary greatly in their approach.