Alternative investment strategies used to be synonymous with
hedge funds and the endowments and wealthy investors that bought
into them. But now a growing number of mutual funds are adopting
hedge-fund tactics, from betting on stocks that could decline
(known as shorting) to buying futures contracts to ride market
trends. Alternative mutual funds are cheaper to own than hedge
funds, they're more transparent about what they own, and you can
sell them on a daily basis.
They could also add value to a portfolio. Robert W. Baird, an
investment firm, calculated that for the 20 years through the end
of September 2013, a traditional portfolio with 60% in Standard
& Poor's 500-stock index and 40% in Barclays U.S. Aggregate
Bond index returned an annualized 7.9%. But a portfolio with 50% in
stocks, 30% in bonds and 20% in indexes that included hedge funds
and other alternative strategies returned 8.2% annualized, with
fewer ups and downs.
Explosive growth. Investors still shell-shocked by the 2007-09
stock market catastrophe and anxious to check future losses in both
stocks and bonds are taking notice. From the end of 2007 through
the end of 2013, assets in alternative mutual funds and
exchange-traded funds more than tripled, to $184 billion, according
But adding alternatives to your portfolio is not without risks.
For one, many alternative funds are relatively young, meaning they
don't have much of a record to go on. What's more, their results
can look sickly when the stock market is on a roll. Over the past
five years, the average alternative fund gained just 2.9%
annualized, compared with 18.8% for the S&P 500 (returns are
through June 30). Finally, fees are high; the average annual
expense ratio for alternative mutual funds is 1.9%. That's well
above the average 1.2% annual charge for a diversified domestic
stock fund--though the mutual funds are cheaper than hedge funds,
which can charge as much as 2% a year and claim 20% of profits.
If you're considering an alternative fund, stick with those that
have proven leadership. Also, be sure of what you're getting.
"There can be a lot of variability" in these funds' strategies,
risks and return potential, says Laura Thurow, director of private
wealth management research at Baird. Below are five no-load funds
with solid records (by the standards of this category) and
Judging from its stable returns, you'd never guess that Merger
) owns stocks. But the 25-year-old fund does just that. Merger,
a member of the Kiplinger 25
, invests in stocks of already announced takeover and merger
targets, hoping to capture the last bit of appreciation before a
deal is finalized. Recently, the fund's returns have paled next to
the torrid run of U.S. stocks. Merger earned just 3.8% annualized
over the past five years, trailing the S&P 500 by a huge
amount. But during broad market downturns, the fund has excelled.
It lost just 2.3% in 2008, when the S&P plunged 37%. The fund
has been about 75% less volatile than the overall stock market over
the past ten years.
The fund's performance is likely to improve if interest rates
rise. A well-executed merger-arbitrage strategy typically earns
three to five percentage points per year more than the yield of
Treasury bills (currently about 0%), says Merger co-manager Mike
Shannon. Higher short-term rates, which could come next year,
should lead to higher returns for Merger investors. The fund
charges reasonable fees of 1.26% annually.
Wasatch Long/Short Fund (
) takes more risks. The fund usually starts with a stock position
that's 80% long (a bet that the stocks will rise in value) and 20%
short, and it can adjust from there. At last report, the fund was
83% long and 10% short, meaning it was essentially 73% invested in
stocks. Long/Short won't capture all the gains of a bull market,
but it probably won't stumble as much during selloffs. In 2008, the
fund dropped 20.9%. The fund's annual expense ratio is 1.28%.
Michael Shinnick and Ralph Shive have been at the helm since
Long/Short's 2003 launch. Energy, financial and technology stocks
recently made up the biggest weightings on the long side of the
portfolio. Meanwhile, the managers shorted richly priced growth
stocks, including Facebook and specialty coffee company Keurig
Long/Short tries to deliver stocklike returns with fewer bumps.
If you want a stock fund that will move more independently of the
broad market, check out TFS Market Neutral (
). The decade-old fund closed to new investors in 2009, but it
reopened earlier this year. TFS, which invests primarily in the
stocks of small and midsize companies, maintains its "market
neutral" stance by generally holding an equal ratio of long and
short positions. In selecting stocks, the six managers use
computers to screen for such things as valuation, earnings
surprises and stock-buyback activity. Among TFS's long positions at
last report was Pioneer Energy Services, which has regularly
exceeded quarterly earnings forecasts over the past year. The fund
has shorted Galena Biopharma, which has generated inconsistent
TFS is a classic example of an alternative fund that dances to
its own tune. Last year, it returned just 1.4%, trailing the
S&P 500 by a staggering 31 percentage points. But in 2008, it
lost just 7.3%. Annual fees are 1.81%, about average for the
Pimco All Asset All Authority (
) qualifies for our roster of alternative funds by investing in
nontraditional investments, such as commodities and emerging-market
currencies. Manager Rob Arnott, CEO of Research Affiliates, a
California firm that manages $169 billion in assets, invests in 40
or so Pimco mutual funds. He may also use borrowed money, a
favorite tool of hedge funds, to boost returns.
All Asset All Authority's mission--to deliver annual returns
that average 6.5 percentage points more than the rate of inflation,
as measured by the consumer price index--underscores its
independence from the stock and bond markets. The fund had a
miserable 2013, losing 5.9%. But it gained 6.1% in the first six
months of 2014, and its ten-year annualized return of 6.7% trails
that of the S&P 500 by only one percentage point per year, on
average. In 2008, the fund surrendered 7.5%. The Class D shares are
available through many
s without sales charges. Annual fees total 1.24%.
Stock funds are not the only ones that use alternative
strategies. Bond funds, including Metropolitan West Unconstrained
), have also gotten into the game. The three managers of
Unconstrained Bond, a member of the Kiplinger 25, do not hew to a
specific benchmark, preferring instead to look for what they
believe are the best opportunities in the fixed-income universe.
Today, that includes commercial mortgages and residential mortgages
that aren't backed by government agencies. The managers can also
hedge against rising interest rates (bond prices and rates move in
opposite directions). Lately, they've been doing so by selling
short Treasury bond futures.
The strategy has worked. Last year, when the U.S. Aggregate
index fell 2% because of concerns that the Federal Reserve would
scale back its easy-money policies, Unconstrained Bond gained 2.9%.
The fund is only three years old, but its managers have decades of
experience. Annual fees are 0.99%--higher than we'd like but worth
the price for the extra protection.
Five popular strategies
Bear market. Mainly sells stocks short to take advantage of
declines in individual shares or in the overall stock market. Best
used only to make a short-term tactical bet.
Long/short. Attempts to earn positive returns regardless of
market conditions by holding both long positions in stocks (a bet
that values will go up) and short positions.
Market neutral. Similar to a long/short strategy but holds an
equal ratio of long and short positions to minimize the effect of
Managed futures. Uses futures contracts (agreements to buy or
sell assets at a set price in the future) as a way to profit from
trends in stocks, bonds, commodities and currencies.
Merger arbitrage. Buys shares of takeover targets after a deal
is announced, in hopes of capturing the final few dollars (or
cents) of appreciation once the deal is completed.