U.S. Markets closed

Are Alternative Mutual Funds Too Risky?

Rob Silverblatt

In the aftermath of the 2008 downturn, alternative mutual funds have exploded in popularity. For investors who took a beating that year, the appeal of alternative funds is simple: They offer the prospect of positive returns even when the stock market takes a hit. But do the benefits outweigh the risks?

FINRA, the financial industry's self-regulatory agency, recently warned investors against jumping on the alternative bandwagon without doing their homework. "Compared to a traditional mutual fund, an alternative fund typically holds more non-traditional investments and employs more complex trading strategies," FINRA cautioned in an Investor Alert published last week. "Investors considering alternative mutual funds should be aware of their unique characteristics and risks."

For starters, the term "alternative funds" encompasses a wide range of investment strategies. For instance, a fund that invests heavily in commodities qualifies as an alternative fund. So does a fund that focuses on real estate. And so too does a fund that shorts stocks or makes liberal use of derivatives.

[Read: Should You Have Alternative Investments in Your Portfolio?]

"The strategies alternative mutual funds employ tend to fall on the complex end of the spectrum," FINRA notes. "Examples include hedging and leveraging through derivatives, short selling and 'opportunistic' strategies that change with market conditions as various opportunities present themselves."

Just as alternative funds can employ a wide range of strategies, they can also have a host of different objectives. The one thing that unites alternative funds is that they are not correlated to the stock market. But that's where the similarities end.

Some alternative funds will try to get a positive return each year, regardless of whether the stock market is having a good year or a bad year. These funds, which don't try to beat the market but merely try to stay in the black at any given point, are called absolute return funds. They often operate by hedging, meaning they have both long and short positions in securities. Their short positions are designed to do well when their long positions fail, and vice-versa.

The main risk of these funds is that although they reward investors when the stock market takes a hit, in good years they often lag significantly behind because the hedging strategy mutes returns. In other words, because each part of a particular fund's portfolio is designed to do well when another part fails, there's never an occasion when the entire portfolio is gaining at the same time.

That means since 2009, absolute return funds have by and large been left in the dust. "These ... funds are best equipped to perform well in choppy or down markets," says Todd Rosenbluth, the director of mutual fund and ETF research at S&P Capital IQ. "They're going to succeed in markets that we're not currently operating in."

Meanwhile, other funds try to use alternative strategies to beat the market. The main risk here, of course, is that they often do so using complicated strategies - for instance, currency trading - that may have any number of downsides investors should understand.

Even though alternative funds can come with substantial risks, they can also provide huge diversification benefits through their lack of correlation to traditional investments. So what should interested investors look for when trying to find an alternative fund?

[See: Risky Business: 7 Mutual Funds for Gamblers]

Rosenbluth suggests investors use three criteria to judge alternative funds: size (the bigger, the better, so lack of liquidity isn't a concern), fees and track record. The latter criterion is perhaps the hardest to satisfy, largely because a significant percentage of alternative funds didn't exist prior to the 2008 downturn. For instance, at the end of 2008, there were only 49 absolute return funds in S&P Capital IQ's database. Now there are 382.

As examples of funds that pass the three-part test, Rosenbluth highlights FPA New Income and PIMCO Commodity Real Return Strategy.

FPA New Income is an absolute return fund. However, unlike many of its brethren, it invests in fixed-income securities rather than taking long and short positions in stocks. The fund has a lengthy track record - it has been around since 1969 - and it has proven quite good at obtaining its objective of avoiding negative returns. Notably, since 1984, the fund has earned a positive return each year.

The fund is also large (with $4.8 billion in assets under management) and relatively cheap (its expense ratio of 0.57 percent compares favorably with the average for absolute return funds - 1.5 percent, according to S&P Capital IQ). Like most absolute return funds, though, its focus on positive returns has come with a cost: Over the past five years, the fund's average annual return has been under 3 percent.

[See: Mutual Fund Scorecard: How 6 Famous Stock Pickers Stack Up.]

Whereas FPA New Income's main audience is investors who are worried about losing money, PIMCO Commodity Real Return Strategy caters to those who are concerned about inflation. Despite its name, the fund doesn't invest directly in commodities. Instead, it puts its money in derivatives that give it exposure to commodities investments and in Treasury Inflation Protected Securities.

Unlike FPA New Income, the fund can gain quite a lot in a given year. For instance, it was up 39.5 percent in 2009. But the reverse is also true: The fund lost a painful 43.7 percent in 2008.

Ultimately, the key to investing in alternative funds is to make sure they fit well in your portfolio. "Alternative funds aren't for everyone," Rosenbluth says. "You really have to dig in and do your homework."

More From US News & World Report