The investment community is a dynamic environment, with new products arising constantly to meet the demands of investors. Looking back 20 years ago, products like ETFs, CMOs and target-date funds weren’t in circulation yet, limiting investment options. While some changes like ETFs have been met with mostly positive reactions from investors, others like CMOs ended up being ill-advised products, as seen by the subprime mortgage crisis in 2008.
Despite setbacks, new products will always come into play as financial markets become more globalized and investments become ever more complex. The success and popularity of hedge funds and private equity funds led to the creation of a new type of “alternative” mutual fund class that allows everyday investors to participate, rather than being open to qualified investors only.
Before you dive into these alternative mutual funds though, we need to take a closer look at what they are and what role they can play in your portfolio.
Alternative Mutual Fund Basics
In an attempt to mimic the investment strategies of hedge funds and private equity funds and make them available to investors of all wealth levels, alternative mutual funds were created. These funds use nonstandard investment strategies to generate profits and can be much riskier and more volatile than other mutual funds.
The first type of alternative fund we’ll discuss is the trading-leveraged equity fund. This fund seeks to replicate the returns of its benchmark index at a fixed multiple, generally 2x or 3x returns. So if the benchmark index gained 1%, the leveraged fund would generate 2% or 3% gains. The use of leverage is applied liberally in these funds and can result in extreme short-term volatility. Remember, it might produce returns at an exponential rate, but it also delivers losses at the same pace.
Another common alternative is the long/short equity fund. As the name implies, this fund holds both long and short positions in its portfolio to maximize potential profits from rising and falling markets. The goal here is to generate uncorrelated returns relative to the broader averages and add diversification to your portfolio. Weights can shift throughout the year as management views the markets in a more bullish or bearish light.
Market-neutral funds are similar to long/short equity funds in the sense that they are designed to produce uncorrelated results relative to the broader averages. These alternative mutual funds attempt to generate a neutral position in the markets by shorting 50% of their assets and holding 50% long. The returns on this setup are generally lower than other types of mutual funds, but it’s intended to produce stable returns regardless of market direction. They are low-risk and low-return mutual funds.
The Bottom Line
Adding an alternative mutual fund to your portfolio can be useful if you want some extra diversity or an edge when it comes to returns or stability. It’s not recommended that your entire portfolio be made up of these types of funds, though, but holding a small percentage of your assets in one can be a good idea. Investors should note that these funds are still new to the investment arena and don’t have a long track record on which to base long-term returns or success. If you decide to incorporate one of these into your portfolio, you should keep a close eye on its performance throughout the year to see what kind of trend it follows.