An Intriguing Product That’s Too Complex for Many; Alternative mutual funds have been gaining in popularity, but some advisers urge caution

October 25, 2013

An Intriguing Product That’s Too Complex for Many

By TARA SIEGEL BERNARD

The sales pitches go something like this: A mutual fund that promises to zig when the rest of the stock market zags. Bond funds that protect investors when interest rates rise. Access to the most sophisticated hedge fund managers in the country, even if you’re not particularly wealthy. Many investors and their financial advisers have been lured into these alternative mutual funds, which use an array of complex investment strategies meant to protect clients against steep market declines, for instance, or hedge against interest rate movements. Billions of dollars have poured into these funds during the economic uncertainty of recent years, and total assets, which stand at $234 billion, are already up nearly 33 percent from 2012.

It’s easy to understand why the average investor might be intrigued. Alternatives offer a way to further diversify a portfolio, adding in another layer of protection against market volatility. Long/short equity funds, for instance, which try to minimize an investor’s losses by anticipating whether stocks will rise or fall, dropped 15.4 percent when the market plummeted in 2008, according to Morningstar. That compares with the 37 percent loss logged by the Standard & Poor’s 500-stock index.

And there are plenty of smart financial planners — even those who don’t profit on their investment recommendations — who put anywhere from 3 to 15 percent (or more) of their clients’ portfolios into alternative funds.

So the question becomes: Should you?

The financial advisers I talked to urged extreme caution for the same reason many investors shun traditional actively managed mutual funds. It’s hard to distinguish the skilled money managers from the lucky ones. And even among the seemingly talented, few can sustain a stellar performance over the long haul.

“Most of them have short track records, obscure trading strategies and few to no adequate benchmarks to compare their performance to,” said Milo Benningfield, a financial adviser in San Francisco.

He marveled at some of the funds’ sales strategies. “One pitch I’ve seen says, in effect, ‘I agree completely that this strategy isn’t for everyone and most people should stick with things they know like stocks and bonds. But for someone who’s willing to do a little more work and can grasp the concepts, this strategy offers a prudent method of improving diversification and risk-adjusted returns.’

“In other words,” he said, “you must be a pretty smart dude to even contemplate our strategy.”

For most investors, slogging through a fund’s prospectus will require several visits to Investopedia, and even then, the inner workings will be hard to grasp. Many of them use derivatives, like options, futures or other complex instruments.

Multi-alternative funds may be the most difficult to digest since they include a sampling of several hedge-fund-like strategies. They might include a long/short strategy, a “global macro strategy” (which generally trade on developing economic trends or policies, for instance), managed futures (which invest in futures contracts like commodities and currencies) among several others. In addition, nontraditional bond funds — which have recently ballooned given fears of rising interest rates — hedge risks tied to rates and trade on anticipated moves in bonds.

“It takes a lot of investment knowledge to fully understand these products,” said Derek Tharp, a registered life planner at Mote Wealth Management. “They’re marketed with a shallow representation of what is really going on inside the fund.”

Managing all of that complexity is also expensive. Alternative funds, on average, cost 1.77 percent of assets, according to Morningstar, compared with 1.28 percent for the average actively managed mutual fund. Hedge funds, however, generally charge up to 2 percent of assets and 20 percent of your profits.

Despite the high costs, the money continues to stream in. Alternative funds hold $234.4 billion in total assets, up from about $157 billion at the end of 2012 and $41.8 billion in 2007, according to Morningstar. Year to date, nearly $44 billion flowed into nontraditional bond funds alone, and $14 billion more followed into long/short equity funds.

This year, 55 new alternative funds have been introduced, according to Josh Charney, an alternative investment analyst at Morningstar, bringing the total number of funds to about 400. Even some large hedge fund players — like AQR Capital Management and most recently the Blackstone Group, one of the largest investors in hedge funds — have started to offer alternative mutual funds to regular investors. By contrast, to invest in a hedge fund directly, an individual must be an accreditedinvestor, with an income of at least $200,000 ($300,000 for couples) or more than $1 million in assets.

So why would hedge funds even bother with smaller investors? In a third-quarter earnings conference call with analysts, Stephen Schwarzman, chairman of Blackstone, recently called it a “very big potential market for us” now that they’ve “cracked the code” on how to manufacture their products for mass consumption.

Put plainly: “It’s a way to gather more assets,” said Steven Nadel, a lawyer at Seward & Kissel who represents hedge funds. “Some strategies are very malleable or easily portable from the hedge fund platform to the mutual fund platform. And it’s an easier sell.”

Compared to hedge funds, alternative mutual funds don’t require that you tie up your money for long periods of time and they are more transparent (but still enormously complicated).

AQR Capital Management also came out with several alternative funds in recent years (offered through brokers and advisers), including a long/short equity fund and a managed futures fund earlier this year. Over the last two years, BlackRock, an asset management firm, has introduced six alternative mutual funds.

Blackstone, meanwhile, opened its doors to retail investors through a partnership with Fidelity’s Portfolio Advisory Service (PAS), which manages portfolios for investors with at least $50,000. Blackstone’s Alternative Multi-Manager fund, just two months old, is essentially a mutual fund that invests in a variety of hedge fund strategies, and will be included in some of Fidelity’s model portfolios for clients. The overall goal is to capture some of the profits generated by the overall market, but limit losses.

“The key is to provide individuals with access to high quality managers in a well-constructed, diversified portfolio,” said John McCormick, senior managing director of Blackstone and head of global business strategy for its Hedge Fund Solutions group. It charges 2.4 percent of assets, and includes 12 hedge fund managers, some of whom specialize in, for instance, distressed debt. Others trade on stock price movements, for example, tied to corporate mergers or acquisitions.

Some experts still question whether these strategies are truly importable into mutual fund format. “The track records of hedge funds and private equity funds are based on an illiquid structure that protects the portfolio from panicked selling attacks during down markets, and gives assets time to recover or develop,” said Lydia P. Sheckels, a financial planner and chief investment officer at Wescott Financial Advisory in Philadelphia. “We question how these funds will perform going forward.”