Alternative mutual funds, specifically managed futures funds, are becoming a hot commodity for advisors looking to add diversification and dampen volatility in their portfolios.

But buyer beware: The fees for these funds may dwarf those of other alternative offerings and their non-correlation to traditional asset classes can be misconstrued.

Managed futures funds have been among the fastest-growing alternative investment categories. In a managed futures fund, commodity trading advisors generally manage clients assets using a proprietary trading system or method that goes long or short in futures contracts in areas of commodities, currencies and bonds.

According to Morningstar, managed futures offerings saw inflows of about $3.4 billion in 2011, a 240% rise over the previous year, and the number of managed futures mutual funds grew from one at the beginning of 2008 to 26 funds at the end of 2011.

The ICI Mutual Funds and Investment Management Conference starting today in Phoenix, Ariz., will feature a panel discussion on "Alternative Investment Strategies in the Registered Funds Space" at 2:45 p.m.

Last week, San Francisco, Calif.-based Forward Management, LLC, for instance, launched the Forward Managed Futures Strategy Fund, which the firm markets as a systematic, trend-following mutual fund designed to "generate positive returns in varied market environments while maintaining low correlations to major stock, bond, and commodity indexes."

"In our view, the appeal of managed futures lies in their equity-like return potential and volatility coupled with their historically low correlation to traditional asset classes," stated Forward CEO J. Alan Reid.

The firm even added data to support its view that the asset class has a long-term track record of equity-like returns with the Barclay CTA Index reporting an 11.16% average annual return between January 1, 1980 and December 31, 2011.

Some existing managed futures offerings such as the Altegris Managed Futures Strategy Fund have enjoyed relative success in their early years. The fund last October revealed that it took in more than $1 billion in assets after launching just over one year ago.

Non-Correlated? Great!

Sounds like a winner? Not so fast. According to the Altegris 40 index, a compilation of the 40 largest commodity trading advisors, managed futures lost 3.14% last year, and the 13 managed futures funds tracked by Morningstar averaged a negative return of 6.92%.

In comparison, the Nasdaq Composite dropped 1.8%, the S&P 500 was flat, and the Dow Jones Industrial Average gained 5.5%.

The index also revealed that during the last 10 years, managed futures had a correlation of minus 0.09 to the Standard & Poor's 500, 0.03 to international stocks, 0.16 to U.S. bonds, and 0.21 to commodities (a correlation of 1 means they move in perfect unison, 0 means their movements are random, and minus 1 means they move in opposite directions).

Greg Anderson, chief investment officer of Denver-based Princeton Fund Advisors, LLC, says some advisors think managed futures funds should be up when the markets are down, which is not quite the case. "Zero correlation means you're moving in no discernible pattern versus negative correlation. So there are times when managed futures can be down when the markets are down," he says.

"Lack of correlation means you're trying to get a different return pattern that's not predictable to what other markets are doing."

Jon Sundt, president and chief executive of La Jolla, Calif.-based Altegris, echoes Anderson's sentiments. "Last year, managed futures was down 3%, which wasn't a great year, but futures are a long-term workhorse so you don't time managed futures," says Sundt. "When the markets were down 13% in Q3, managed futures was up 3%. So if you had futures in your portfolio last year, it didn't increase your returns but lowered your volatility."

Sundt also noted that during the financial crisis in late 2007 to early 2009, managed futures was up 19% while equities sank 50%. "So to have a 15-20% allocation to futures during that crisis would've saved advisors' clients a lot of pain," he says.

But They're Not Cheap

But non-correlation is not cheap. The Princeton Futures Strategy fund charges 220 basis points for the A shares and the Altegris Managed Futures Strategy fund, a fund of funds, has a net expense ratio of 386 bps for A shares. Sundt says his fund's high fees give advisors access to a blue-chip roster of CTAs.

"We think talent is worth paying for and advisors have to understand that long-term, you want managers with deep infrastructures and research backgrounds," he says.

Although his managed futures fund hasn't made any money yet (it is down about 3% since inception in August 2010), Sundt says demand has been "spectacular" among advisors who recognize the underlying talent. "But managed futures is a long-term hold and we're very excited about the prospects for that fund," he offers.

Another misunderstanding among advisors is that there is also not a consistent set of rules of how to look at the expenses in managed futures products, according to Pat Meehan, chief investment officer of Chicago, Ill.-based Grant Park Fund. "So underlying traders' expenses don't really show up anywhere in the mutual fund world and that's where advisors get confused," says Meehan. "The Commodity Futures Trading Commission is currently working with the Securities & Exchange Commission right now to harmonize their disclosure requirements to get everyone on the same playbook."

In fact, on February 9, the CFTC issued final rules eliminating a number of exclusions and exemptions relied on by commodity pool operators and CTAs and increasing the reporting requirements for registered CTAs and CPOs. Additionally, the agency also said that: "The operators of managed futures funds registered with the SEC as investment companies will no longer be able to rely on an exclusion from registration as CPOs under CFTC Rule 4.5."

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