- Amid a rocky few years for U.S. stocks, investors have poured billions of dollars into "alternative" mutual funds, which employ strategies used by hedge funds to protect against stock-market declines while still providing growth. In general, the funds have held up reasonably well during stock-market selloffs—but many have squandered that advantage by missing out on rallies.
- Investors have flocked to alternative mutual funds in recent years, and more than half of all such funds have been launched in the past three years. (I was ahead of the curve) Assets in the two biggest categories have essentially doubled—to $18.6 billion today from $10 billion in 2006 for "long short" funds and to $20 billion from $7.4 billion for "market neutral" funds over the same period.
- The recent period of high volatility "is precisely the market environment when you would want these funds," says Nadia Papagiannis, an analyst at investment researcher Morningstar. But she calls the funds' three- and five-year track records "disappointing."
- Alternative funds typically have wide latitude to reduce their exposure to the stock market by using futures, options and other derivative instruments, and by selling stocks short—that is, betting that a security's price will fall. Some pursue "arbitrage" strategies, which involve betting on price discrepancies between investments.
- Long-short funds can bet both for and against stocks and are designed to lose much less than the stock market during downturns. Over the past three years, they have fallen by an annualized 1.17%, according to Morningstar. By contrast, the Standard & Poor's 500-stock index gained an annualized 0.02%. Over the past five years, the category posted an annualized loss of 1.28%, versus a loss of 0.9% for the S&P 500.
- From Jan. 1 to July 22—a period in which the S&P 500 jumped 8.1%—the average long-short fund gained just 1.25%, participating in only 15% of the market's rise.
- Managers say long-short funds have performed as they should. This breed is "not designed to slaughter the S&P 500," says Jonathan Lamensdorf, manager of the Highland Long/Short Equity Fund, which has outperformed most of its peers over the past three years. Instead, he says, the funds strive to provide returns similar to equities, with fewer ups and downs.
- While market-neutral and long-short funds still dominate the alternative-funds category, it has expanded in recent years to include currency funds as well as managed-futures funds, which can invest in futures contracts in a variety of markets; bear-market funds, which profit when markets decline; and multi-alternative funds, which use a variety of strategies.
[June 11, 2010: CBSMarketwatch - More Investors Turn to Flexible Mutual Funds]
[Nov 24, 2009: Bloomberg - Investors Rushing into Alternative Mutual Funds]
[Nov 12, 2009: WSJ - More Mutual Funds Attempt to "Time" the Market]
[Aug 4, 2009: WSJ - Mutual Funds Try "Hedge" Approach in Effort to Trim Stock Losses]
[Apr 10, 2009: More Stock Mutual Funds Declare Cash is King]