Finra

Connie Chew/The Wall Street Journal

“Alternative” investing is big these days—and that popularity is partly why products touted as being better than conventional offerings have been singled out by a financial regulator among areas of concern.

The Financial Industry Regulatory Authority lists sales practices involving “alternative mutual funds” and funds tracking “alternatively weighted” indexes among numerous areas of focus in its just-released list of regulatory and examination priorities for 2015. (Another concern: securities-backed lines of credit .)

Alternative Mutual Funds

The Finra letter notes that sales of alternative funds have increased rapidly as the funds have multiplied. These funds may invest in asset classes other than mainstream U.S. stocks and bonds—such as a mix that includes commodities futures and  foreign bonds issued in local currencies—and/or in nontraditional, hedge-fund-like strategies such as buying some holdings while betting against others.

A key recommendation from the financial industry’s self-regulator:

Finra recommends firms refer to such funds based on their specific strategies, as opposed to bundling them under one umbrella category.

In its letter, Finra says it is concerned that advisers and customers “will not understand how the funds will respond to various market conditions”—or  even know the strategy a fund may use in various market conditions.

In an interview, Finra Chairman and Chief Executive Richard G. Ketchum said, “We are concerned that this is a bit of an accident waiting to happen.” He noted that the alternatives area is complex, with a wide variety of strategies and managers having substantial discretion in how they operate.  Also, “the fees, relative to other mutual-fund investments, are quite large,” he said.

It’s too early to say whether investors have already invested too much in alternatives, he said, “but the risk of that concentration is there.”

Funds Tracking Alternative Indexes

A separate stream of alternative investing involves exchange-traded funds that track indexes that are very different from conventional benchmarks.

Traditional indexes such as the S&P 500 weight their holdings based on their market value. By contrast, some alternative indexes hold positions of the same size in all of the stocks in a benchmark. Others set their exposure to different stocks based on their volatility or on “fundamental” factors such as companies’ dividends and sales.

Funds tracking such indexes may be marketed as providing better risk-adjusted performance, Finra notes. But there are also potential negatives:

[Exchange-traded products] tracking these indices may be thinly traded and have wide bid-ask spreads, making these funds more costly to trade, in addition to their generally higher expenses. Some alternatively weighted indices may have significantly higher turnover than more traditional indices, leading to greater transaction costs for ETPs that track them.

Some of these index products have been marketed based on “back testing”—projections of how they would have performed in past periods if they had existed.  But as Finra notes:

…it remains an open question how the indices and products tracking them will behave in different market environments going forward.

Matthias Rieker contributed to this article.