A few weeks ago the Financial Industry Regulatory Authority rang an alarm bell regarding the burgeoning alternative mutual fund asset class in hopes that the average retail investor will do their homework before diving into these funds.
According to FINRA, in addition to the usual market and investment specific risks mutual funds have, alternative mutual funds carry additional risks from the strategies they use. For example, market-neutral funds tend to have significant portfolio turnover risk that can result in higher costs. Similarly, a distressed bond fund is likely to have significant credit risk.
Alternative mutual funds can also be pricey versus their traditional mutual fund peers, sporting annual operating expenses well north of 150 basis points. Also, many alternative funds have limited performance histories dating back to post-2008, so it is not known how they will perform in a down market.
"Investors should fully understand the strategies and risks of any alternative mutual fund they are considering," according to Gerri Walsh, FINRA's senior vice president for Investor Education. "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."
How about a second opinion? Mallory Horejs, an alternative investments analyst at Morningstar, advised investors to avoid over-priced multi-alternative funds with net expense ratios above 300 basis points, as well as funds-of-managed futures fund that invests in hedge fund managers that do not fully disclose their fees.
"My main message to investors with no experience using these products is that they should access these strategies through an advisor," said Horejs. "Liquid alternatives are more complicated than long-only strategies, and though they can certainly benefit a portfolio in terms of diversification, risk-adjusted returns, and downside protection, they're still best selected by someone who is more knowledgeable and experienced in the area."
In terms of the specific, "starter" allocations, Horejs said investors should select a multi-alternative fund, which allocates across strategies and asset classes and essentially provides a one-stop-alternatives shop, or select a long/short equity, market neutral, and managed futures fund, and equally weight across the three.