As stock and bonds prices move up and down, investors may seek investments that don’t act exactly like these traditional securities.
Enter alternative funds, which are often designed to move out of step with other traditional investments, helping investors build a diverse portfolio that has some measure of protection against market risk.
Though handy tools for diversification, these funds are not necessarily appropriate for all investors, so before buying investors should do their best to understand them.
What Are Alternative Funds?
Generally speaking, alternative funds for the average investor refer to mutual funds or exchange-traded funds (ETFs) that use nontraditional investments and trading strategies to help them meet their fund objectives.
Alternative funds might invest beyond core investments—including stocks, bonds, cash, and cash equivalents—to focus on alternative investments such as real estate, commodities, loans, and even unlisted securities.
What Are Alternative Investments?
Alternative investments are asset classes that don’t fall into the traditional categories of stocks, bonds and cash equivalents that likely make up the bulk of an average investor’s portfolio.
Though spoken of collectively, alternative investments are not a unique asset class unto themselves. Perhaps a better way to think of them is as different approaches to investing across a variety of asset classes and markets.
Common alternatives include:
Investing in real estate may offer investors low correlation to the stock and bond markets. As a result, this asset class is often used as a way to diversify portfolios and alternative income streams.
As a category, commodities include natural resources and food, such as oil, energy, metals, minerals, corn, and even pork bellies. Prices of commodities rise and fall with demand, and they are often used in portfolios as a hedge against inflation.
Hedge funds and private equity funds
Though these are alternatives and funds, hedge funds and private equity funds are not traded like alternative mutual funds and ETFs and can, in fact, be hard for investors to access.
Additionally, hedge funds act very differently than alternative mutual funds and ETFs. More on these differences later.
Alternative investments can also include things you might be surprised to see in an investment portfolio, including art and collectibles, intellectual property rights, and private equity.
What Strategies Do Alternative Funds Use?
Alternative funds typically use a broad range of complex investment strategies. Some funds will use one single strategy, such as investing entirely in currencies, for example.
Others may use multiple strategies, and still others may be what are known as “funds of funds.” These special alternative funds can hold multiple funds that use multiple strategies. Here’s a look at some of the strategies alternative funds might use:
Hedging is strategy to help protect investments from the risk that they will lose value. Many investing strategies use derivatives, which get their value from underlying assets such as stocks or bonds. For example, an option is one of the most common types of derivative, and gives investors the right to buy or sell a stock at a set price within a given timeframe.
At its most basic definition, leverage means debt. A leveraged fund is one that uses debt to increase gains within a short period of time. Leveraging can be a risky strategy because the fund that is taking on the debt is beholden to its creditors should its investments fail.
Short selling is an investment strategy that allows investors to profit from securities when their value falls. To carry out a short sale, an investor first borrows a security from someone who owns it. The investor sells the security, and hangs on to the cash they make from the sale. At that point, the investor hopes that the price of the stock will fall, at which point they can buy back the same stock for less than they sold it for. Then they can return the shares they borrowed and keep the money that’s left over as profit.
Market neutral strategy
The aim of market-neutral funds is to provide stable returns in various market conditions. The fund does this by balancing a mix of short and long positions regardless of whether the market is moving up or down. Going “long” on a stock simply refers to buying a stock with the expectation that its value will rise. As a result, these funds can help insulate investors from market swings.
Investment strategies that change with market conditions as various opportunities arise.
What’s the Difference Between Alternative Funds and Hedge Funds?
Investors may see alternative mutual funds and hedge funds discussed in the same breath, but there are some key differences between the two. Chief among them: The Investment Company Act of 1940 limits the operations of alternative mutual funds. These rules do not apply to unregistered hedge funds.
Protections under this act include limits on leverage and illiquid investments, diversification requirements, daily pricing, and rules governing the redeemability of fund shares. These regulars act as safeguards that protect consumers. Hedge funds are not subject to these limitations so they are free to pursue strategies not limited by the same regulations.
What’s more, hedge fund advisors are allowed to charge investors a “2/20” performance fee for advising the fund. This fee structure refers to a 2% annual management fee charged by the company for managing the assets and a 20% performance incentive fee charged against any profit made above a certain level. Alternative mutual funds and ETFs are not allowed to charge investors this kind of fee.
Who Can Invest in Alternative Funds?
Anyone can invest in alternative mutual funds and ETFs. In the past, gaining access to alternative investments wasn’t always so easy. One of the hallmarks of some alternative investments—such as hedge funds—is a high barrier to entry.
Many require that individuals be accredited investors or “qualified purchasers” before investing in them. These designations mean that an investor has met strict income or net worth requirements.
These rules were designed to limit some alternative investments to people who are financially sophisticated and can generally take on the increased financial risk that the investments might carry.
Some Things to Consider Before Investing in Alternative Funds
Alternative funds can be complicated investments, given the strategies and asset classes involved. Before investing, individuals should consider the following:
Like other mutual funds and ETFs, alternative funds are managed according to a set of specific investments objectives, which can help investors determine what role they may play in their portfolios. For example, a fund might seek to offer broad diversification through currencies, commodities or even other alternative investments. Or they may seek to capitalize on specific expertise into a market niche, such as distressed companies. Investors may want to carefully consider whether a fund’s objectives line up with their own goals.
Most alternative funds are actively managed. That means a human being—as opposed to a computer algorithm, for example—is making investment and strategy decisions for the fund. As a result, it’s important to learn as much as possible about who is managing the fund. Research what you can about their experience, how long they’ve been managing a particular fund, and their track record. You can find out more about the backgrounds of fund managers with FINRA’s BrokerCheck . Investors can enter the name of a manager or their firm to find out about their experience and any past issues that may raise red flags.
Market risk is the risk that investments will lose money as a result of overall market conditions. Alternative funds do not invest in traditional investments. As a result, investors should understand that prices of alternative funds may be more volatile than core investments such as stocks and bonds.
Alternative funds often require more research and may require more frequent trading compared with other active mutual funds or ETFs. All that activity can translate into higher management fees. Alternative fund expense ratio—total operating expenses dividing by average dollar value of assets under management—can be as high at 1.5%. More traditional funds, on the other hand may have fees that hover more in the 0.50% range.
Alternative funds do not always have a clear legal structure and may not be that transparent. As a result the contents of a fund may be hard for the individual investor to parse. Before buying a fund, investors may want to do their best to understand that fund’s objectives, and what types of investments it holds.
This includes paying special attention to the structure of alternative funds. These investments may provide more diversification than single- or multi-strategy alternative funds. However, that very diversification can cause some disadvantages. For example, there may be a flattening of returns, less transparency, or even an inability to reallocate investments within the fund or funds that would be beneficial to its performance.
Investment performance is never guaranteed. And while investors can’t predict the future, past performance can give them an idea of what they might expect. Investors can consider long-term returns of five years or more and may want to steer clear of funds with short investment histories. Without a long track record, it’s hard to see how these funds have performed under various market conditions.
The specific strategy an alternative fund pursues may come with its own set of risks. For example, if a fund takes a market neutral strategy, it may have to do a lot of buying and selling within the fund. This increased turnover can lead to higher costs for investors. This means it’s worth paying attention to fund strategies and researching the types of risk that may be associated with them.
How Do Alternative Funds Fit in a Portfolio?
Alternative funds can be a useful way for investors to diversify their portfolios. A diversified portfolio is one that holds a mix of different asset classes. Ideally investors would then diversify within each asset class, choosing investments with differing factors such as geography or size, for example.
Diversification can help protect investors against market risk. The idea is that different types of investments tend not to move in lockstep with each other. So when markets are on the move, different investments will theoretically react differently. When one is down, another may be up.
Alternative investments can have low correlation with traditional investments such as stocks and bonds. In other words, their movements don’t track closely to these traditional investments, which may provide protection in a portfolio if one of these asset classes hits a rough patch.
Alternative funds can provide access to otherwise-difficult-to-access markets for a retail investor. For example, if you’re interested in investing in global real estate, that might be difficult to do without feet on the ground abroad.
However, an alternative mutual fund that focuses on real estate in other countries can help give you access to an otherwise tricky market to break into.
In some cases, alternative funds can be riskier than their more traditional counterparts. They may offer greater upside potential, but the flipside is they may fall harder.
As a result, investors may want to consider their overall goals and personal risk tolerance when choosing whether to invest in alternative funds making sure to align any investments they choose to those goals.
Investing in Alternative Funds
If you’re ready to put some money toward investing in alternative funds you can do so through a brokerage account or a retirement account, such as a mutual fund or 401k.
With SoFi Invest®, investors interested in a hand-on approach to investing can set up an active investment account where they can handpick investments they want to buy.
Investors who are more prone to a hands-off approach can set up an automated account with a portfolio built based on their personal goals, time horizon, and risk tolerance.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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