By Dan Weil • Bankrate.com

Investing » Alternative Mutual Funds: Are They Worth It?

Liquid alternative mutual funds represent one of the fastest growing asset classes around, and many investment experts say they can make a useful addition to your portfolio.

The alternative part of the funds’ name reflects their difference from standard long-only stock, bond and commodity funds. In that sense, they are like hedge funds.

But the liquid part sets them apart from hedge funds. Unlike hedge funds, liquid alternative funds can be sold on a daily basis, just like other mutual funds.

Investors should look at these funds, but you need to look more closely at them than your typical stock fund, says Josh Charlson, director of manager research for alternative strategies at Morningstar research firm in Chicago. They tend to use more complicated strategies. You need to understand their role in a portfolio.

Growing numbers

Though they are not commonly found in 401(k) plans, the number of liquid alternative funds and the amount of assets they control have soared over the past few years. There are now 465 such funds, up from 242 five years ago. The funds enjoyed a net inflow of $14.64 billion in the first half of the year, according to Morningstar.

A lot of it (the growth) is a reaction to the (2008-09) financial crisis and the steep losses you saw in portfolios with a lot of exposure to stocks, Charlson says.

There’s also a recognition by investors and advisers that to the extent you can smooth out volatility in a portfolio, it leads to a better experience. The option to invest in an alternative strategy in a more liquid and transparent form has appeal.

5 types of alternative mutual funds

Morningstar classifies liquid alternative funds into five main categories: long-short equity, market neutral, managed futures, multi-alternative and nontraditional bond funds.

Long-short equity funds offer an exposure to both long and short stock positions. Most investors take long positions, expecting their holdings to rise in value. Short positions enable investors to make money when stocks decline. The idea of combining strategies is to limit your losses when stocks drop. Of course, that means your gains will be limited when the market rises. The funds usually capture some of the market’s upside, but less of the downside, Charlson says. On average, they move up and down half as much as the market.

In market neutral funds. managers seek to hedge out all of the systemic market exposure. So if it’s a stock fund, your return shouldn’t be affected by whether the market as a whole rises or falls. An example would be a merger arbitrage fund, in which a manager might go long stocks of potential takeover targets and short stocks of potential acquirers.

The funds tend to have low, single-digit steady returns, Charlson says. They have low correlation to stock and bond markets.

Managed futures funds trade in a variety of asset classes using derivatives. It could be a mix of equity futures, currencies, commodities and fixed income, Charlson says. It’s usually a quantitative model, often following three- to 12-month trends. Historically, they’ve had a low correlation to stocks and bonds.

Multi-alternative funds are modeled after hedge funds of funds. They usually package multiple alternative strategies in a single fund. They could have long-short funds, managed futures funds, event-driven strategy funds and others that we don’t even classify, Charlson says.

They often have a defined return target, such as a certain percentage over the Libor rate, a benchmark interest rate. And they aim for lower volatility than the stock market.

But, we’ve found they have a pretty high correlation to the S&P 500 index, Charlson says. That’s something you want to be aware of. You’re usually looking for lower correlation.

Nontraditional bond funds generally choose between two approaches. One is an unconstrained strategy in which the manager isn’t tied to a benchmark and can choose any bond in any market. Then there are credit-based long-short funds. Managers choose their positions by focusing on the fundamentals of individual bonds.

Diversification and performance

What are the benefits of investing in liquid alternative mutual funds?

You get access to different types of strategies and asset classes that will ideally provide diversification in your portfolio that you can’t get from just stocks and bonds, Charlson says. And the funds can ultimately improve the risk-adjusted performance of your portfolio.

Financial advisers find the funds helpful for their clients in providing diversification and reducing volatility. We do use them. As that industry matures, there is probably some good stuff coming down the pike, says Lane Jones, chief investment officer of Evensky & Katz/Foldes Financial Wealth Management in Coral Gables, Florida.

There was too much correlation (in investors’ portfolios) during the financial crisis. Now they are looking for better diversification.

Liquid alternative funds averaged annual returns of 5.9 percent for the 12 months ended in August, 3.9 percent for the past three years and 4.9 percent over five years, according to Morningstar. That compares with 25.2 percent, 20.6 percent and 16.9 percent, respectively, for the Standard & Poor’s 500 index.

In times when U.S. equities and growth are going well, most of these strategies will trail, says Certified Financial Planner professional Jim Holtzman, CPA and shareholder with Legend Financial Advisors in Pittsburgh. You have to have a full-cycle mentality. If you look back to 2000, then some of these funds look good.

Implementation deficiencies

Despite the funds’ weak recent performance, alternative strategies are appropriate, but it’s the implementation that leaves something to be desired, says portfolio manager Gary Herbert of Brandywine Global in Philadelphia, who helps manage a nontraditional bond fund, the Legg Mason BW Alternative Credit Fund.

Perhaps the biggest disadvantage of liquid alternative funds is their cost. They have an average expense ratio of 1.78 percent, compared with 1.31 percent for actively managed equity mutual funds, according to Morningstar. Still, these fees pale compared to those of actual hedge funds that typically charge a 2 percent management fee plus 20 percent of the profits.

Liquid alternative mutual funds also are difficult to understand compared with their plain-vanilla brethren. These are certainly more complex investments, Jones says. They often bring in derivatives. That obviously brings in risk, and the average investor loses the ability to understand.

Do they measure up?

Jones also questions whether liquid alternative funds can live up to the mystique of hedge funds, which routinely invest in illiquid assets and make big, concentrated bets. Managers generally can’t do those things in a mutual fund, he notes. (The success of hedge funds) may not be transferable.

Another wrinkle: The Securities and Exchange Commission recently announced it is formulating new rules to boost oversight of alternative mutual funds and is looking at ways to limit their strategies — particularly those of long-short funds and funds using derivatives. Of concern to the SEC is how they might pose a risk to the financial system if the funds had to meet widespread investor redemptions.

If you’re going to take the plunge into liquid alternative mutual funds, you want a diversified exposure to different alternative strategies, Charlson says. You can get that through a multi-alternative fund or through a group of funds encompassing different categories.

Investing 5 percent to 20 percent of your assets in liquid alternative funds makes sense, he says.