‘Alt’ Funds: What Investors Need to Know

Alternative, or “alt funds,” are not your typical mutual fund. As reported June 11 by USA Today, the past three years have seen a boom in so-called alt funds, and while it’s been tremendous for the companies that offer these funds, it’s been a bust for investors.

Alt funds might invest in assets such as global real estate, commodities, leveraged loans, start-up companies and unlisted securities that offer exposure beyond traditional stocks, bonds and cash.

These funds also may employ complex strategies, including hedging and leveraging through derivatives and short selling. Some alt funds are structured as a fund containing numerous alternative funds. Although the strategies and investments of alt funds may bring to mind those of hedge funds, alt funds are regulated under the Investment Company Act of 1940, which limits their operations in ways that do not apply to unregistered hedge funds.

Alt funds now have about $250 billion in assets. As for their record, it’s pretty dismal. According to the USA Today article, bear-market funds, which rise when the stock market falls, have fallen an average of 64% over the past three years vs. a 62% gain for the average fund that tracks the Standard & Poor’s 500-stock index.

Last week, the Financial Industry Regulatory Authority (FINRA) issued an investor alert on alternative funds, which cautioned that these products carry distinctive qualities and risks that investors may not thoroughly understand until it’s too late.

“FINRA is warning investors to carefully consider not only how an alt fund works, but how it might fit into their overall portfolio before investing,” said Gerri Walsh, FINRA’s senior vice-president for investor education, in a statement.

Among the information and advice FINRA outlined in its new investor alert:

Investment Structure: An alternative fund of funds may offer greater diversification than a single-strategy or even multi-strategy alt fund. At the same time, this greater diversification may lead to a flattening of return and potentially less transparency.

Strategy Risk Factors: In addition to the usual market- and investment-specific risks mutual funds have, alt funds carry risks from the strategies they use.

Investment Objectives: One fund might be designed to capitalize on management expertise in a specific area (e.g.investing in distressed companies), while another might seek exposure to commodities, currencies and other alternative investments.

Operating Expenses: Alternative mutual funds can be pricey relative to their traditional managed fund peers; the average annual operating expense is around 1.5% per year.

Fund Manager: Learn as much as you can about the fund manager, such as how long he or she has managed the fund. Research the professional background of a fund manager using FINRA BrokerCheck.

Performance History: Many alternative funds have limited performance histories. For example, a fair number were launched after 2008, so it is not known how they might perform in a down market.