Hedged funds are usually reserved for institutional investors and for the very wealthy. Alternative strategies are now available to ordinary investors. These funds must adhere to a higher level of transparency and liquidity than hedge funds or limited partnerships.
Ever since the crisis of 2008–2009, financial advisors and their clients have looked for ways to shield portfolios from potentially devastating losses. Many set their sights on liquid alternatives funds, an emerging investing category that’s sold as both mutual funds and exchange-traded funds.
In 2008, just $44 billion was invested in alternatives through mutual funds and ETFs, according to research firm Morningstar. At the end of 2015, however, assets had exploded to $300 billion, with close to 600 funds.
There are a large selection of alternative strategies available. When the market faltered in 2008, managed futures and interest–rate swaps funds were up in value while stock holdings were down. Other categories include strategies, such as market neutral, commodities, multi-asset, multi-currency and long/short equity.
Some advisors use liquid alternative funds as a way to deal with the current low-interest-rate environment. Bonds are dead money right now and stocks themselves aren’t cheap. Advisors are essentially eliminating bonds and replacing them with something that will serve the same purpose, but also offer some potential return. A very popular choice to protect your equity exposure is a long/short strategy. These fund managers buy stocks that they expect will rise in value (long), while shorting those they expect will fall.
Most advisors use alternative funds as ballast during falling markets because they invest in non-traditional assets that aren’t correlated with stocks or bonds. Investment experts recommend a meaningful allocation of 15 percent to 20 percent; otherwise, the impact won’t be felt. Trying to predict when markets are likely to fall and inserting an alternative fund is very hard to do.
While alternatives might fare better than a mainstream stock/bond portfolio in a downturn, they’ve got their own drawbacks. The big one is fees.
According to Morningstar, the average expense ratio of alternative funds is 1.7 percent, many times that of either equity or bond funds. “The high fees have eaten into returns, which is a concern when it’s generally a lower-return environment,” said Josh Charlson of Morningstar.
However, compared to the fees that such strategies charge in the hedge fund structure, they’re a bargain. Investors in hedge funds normally pay 2 and 20 — a 2 percent fee on assets under management, plus 20 percent of profits.
Now I believe that this low-interest rate environment may continue for another decade so investing in fix income products doesn’t make sense. Sitting on cash that yields nothing or being 100% invested in stocks is overly risky.
I recommend checking the fees that your company’s pension plan provider charges. Switching from fix income to an alternative fund may be more economical than you think. A word of caution, before you invest in any alternative fund, make sure you understand the strategy, the risk and the fees.
What are your thoughts on alternative funds and ETFs? Are they suitable for your retirement fund?