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"Alternative" funds aim to offer investors diversification from the ordinary moves of stocks and bonds. Last year, however, diversification often meant lower returns.
Nearly 1,400 mutual funds and exchange-traded funds fall into the alternatives category, according to Chicago-based research firm Morningstar. Some place complex bets on stocks and bonds, rather than simply buying and holding them. Others hold less traditional assets for individual investors, such as commodities and currencies.
The idea, typically, is to provide exposure to a fund that might zig when other investments zag — and in 2013, many alternative funds did just that. As a group, alternative funds gained 6% on average, compared with a 32% gain for the S&P 500 (.SPX), including dividends, and a 2% loss for the Barclays U.S. Aggregate Bond Index.
Investors who embraced the strategies often made less than they would have with a more plain-vanilla approach.
For instance, long/short equity funds — which place bets that some stocks will rise in value and others will fall — gained just 15% on average. Funds that aim to profit from falling stock prices did even worse, losing 35% — no surprise, given last year's bull market.
By contrast, an investor who held the passively managed Vanguard Total Stock Market ETF (VTI), which tracks an index of most domestic stocks, would have made more than 33%.
Many alternative funds have high fees, which eat into returns. The average mutual fund in the category charges annual fees of 1.74%, or $174 on a $10,000 investment, according to Morningstar — compared with 0.73% for the average long-only stock mutual fund.
"People need to be cautious about jumping into alternative strategies. They can be much more complex and costly to own than a traditional fund," says Andrew Ahrens, chief executive at Ahrens Investment Partners, in Lafayette, La., which manages $800 million in assets.
In their use of more-complex investment strategies, alternative funds can function as hedge funds for the masses. Hedge funds typically are available only to large institutions and wealthy individuals and often charge investors steep fees. Hedge funds across all strategies returned 9% on average last year, estimates Chicago-based data tracker HFR.
Investors poured $49.1 billion into alternative funds in 2013, up from $13.9 billion the prior year, according to Morningstar.
Money managers sometimes use alternative funds to magnify their wagers. Funds that use borrowed money to double-down on bullish stock bets gained an average 54% in 2013.
But trying to use alternative funds to beat the market is risky, says Gerry Klingman, a financial adviser in New York who oversees $1.3 billion. He prefers using alternative funds that hedge their bets.
For example, he favors fund managers who try to capture most of the stock market's upside, but with less volatility. Mr. Klingman puts some client money in the Robeco Boston Partners Long/Short Research Fund (BPIRX), which gained almost 18% last year, and which charges individual investors annual fees of 1.73%. Mr. Klingman buys less-expensive shares available to large investors.
Investors who are particularly bullish on stocks might want to try an alternative fund that uses a "130/30" approach, says Scott Kubie, chief investment strategist at CLS Investments in Omaha, Neb., which manages $6 billion.
Such funds might buy $100 in stocks while shorting $30, for instance. Taking short positions typically involves selling borrowed shares now and buying them back later, hopefully at a lower price so the investor can pocket the difference.
The proceeds from the short sales can then be used by managers of these types of funds to buy another $30 in shares, leaving the fund 100% net long — just as with a long-only stock fund. But investors could benefit from the manager's ability to choose the right gainers and decliners, rather than just winners.
The goal of 130/30 strategies is to amplify returns rather than reduce risk, says Mr. Kubie, who advises investors to use those types of funds only in small doses.
Portfolio managers at Mr. Kubie's firm currently use the ProShares Large Cap Core Plus ETF (CSM), which charges 0.45%. The fund tracks an alternative index that has outperformed the S&P 500 index over the past 12 months, he says, showing that "some alternative-fund strategies can work well given the right market conditions and the right portfolio makeup."
Investors who want to hedge their portfolios in a more-conservative manner might want to consider market-neutral funds, says Mark Luschini, chief investment officer at Janney Capital Management in Pittsburgh, with $3.3 billion in assets.
In these types of funds, a manager might take a long position in Ford Motor (F), for example, while at the same time establishing short positions in General Motors (GM).
"Managers of these funds are essentially trying to keep their exposure to the broader market neutral, but tilting their long and short positions between different industries and markets," Mr. Luschini says.
One of his favorites is the Merger Fund (MERFX), which tries to take advantage of pricing aberrations in the shares of companies that are buyers and sellers in corporate transactions. The fund, which charges 1.27% in annual fees, gained 3.6% last year.
Mr. Ahrens also believes that a well-researched mix of alternatives in a stock-heavy portfolio can help give investors a smoother ride over time.
"Bonds are still going to be the cheapest and most straightforward way to protect against market downturns," he says. "But alternative funds can provide more stability for a long-only portfolio to offset ongoing market fluctuations."
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.