Alternative mutual funds can help retail investors diversify a portfolio away from stocks, bonds and cash. Explore the pros and cons.
Alternative mutual funds can help investors achieve greater diversity in a portfolio composed primarily of traditionally held stocks, bonds and cash.
Diversification is one of the cornerstones of modern portfolio theory, which states that assets spread over a wide range of financial products is less prone to risk and can better weather a sharp downturn in any one asset class. The theory is built on historical data that shows that assets, such as stocks and bonds, perform inversely to each other. That is, when stocks are up, bonds are down.
The prolonged financial downturn and unusually volatile financial markets are testing the limits of modern portfolio theory. According to Dr. Christophr Geczy, of The Wharton School, the theory did not fail during the credit crisis, but portfolio construction did. Many investors did not have exposure to enough different asset classes, said Geczy. That growing realization is driving an increasing number of investors to alternative investments, such as gold and other commodities. Some investors are seeking higher yields, some a safe haven in an uncertain economic environment. Retail investors seeking these advantages can choose from a variety of mutual funds invested in alternative financial products.
Morningstar Inc., which tracks the performance of the mutual fund industry, divides alternative mutual funds into seven broad categories: Long/Short Equity, Equity Precious Metals, Multialternative, Currency, Market Neutral, Managed Futures and Bear Market. Data released by Morningstar yesterday shows that five-year returns for these funds range from -17.42 for the Bear Market category to 10.11 for Equity precious metals. In comparison, Domestic Stock Funds averaged 6.47 percent over five years. International Stock Funds – led by Latin America and Asia – showed a similar five-year gain of 6.73 percent, and were bested by the 7.96 percent five-year gain in emerging market bond funds.
Alternative funds seek to provide downside protection during “tumultuous” markets and positive returns over the long run, according to Morningstar contributor Mallory Horejs, who explains, “These funds employ techniques such as short-selling or hedging, with the intent of generating an attractive long-term, risk-adjusted return with low correlation to traditional stock and bond markets. Not all of these funds have performed as advertised, however.”
One of the newest entries into the alternative mutual fund market is the BlackRock Emerging Markets Long/Short Equity Fund launched last October. The fund ranks 1,200 emerging market stocks into long/short value pairs in order to generate returns regardless of whether markets are “trending up, down or sideways,” notes BlackRock. The company notes that for a minimum investment of $1,000 an investor can gain exposure to an asset class that’s underweighted in most portfolios. Emerging market equity funds constitute only 2.5 percent of investors’ long-term assets, but account for almost 50 percent of global gross domestic product.
High net worth investors tracked in Millionaire Corner’s ongoing research currently allocated 9 percent of their portfolios to alternative investments. The most widely used is a not an alternative mutual funds, but another type of pooled investment called a Real Estate Investment Trust or REIT.