Alternative mutual funds are SEC-registered, publicly-traded mutual funds that employ complex investment and trading strategies. Also called alt funds or liquid funds, alternative mutual funds hold non-traditional investments. As their name implies, alt funds seek to accomplish the fund’s objective through non-conventional investment and trading strategies. Alternative mutual funds invest in assets like leveraged loans, global real estate, start-up companies, commodities, and unlisted securities that provide exposure beyond the conventional stocks, bonds, and cash.
Understanding Alternative Investments
Any financial investment that does not fall into one of the categories of traditional investments is an alternative investment. Private equity or venture capital, managed futures, hedge funds, commodities, art and antiques, and derivative contracts are all examples of alternative investments.
Institutional investors or high net worth individuals/accredited investors hold most alternative investments. This is due to the investments’ complex nature, high degree of risk, and lack of regulation. Many alternative investments have high fee structures and minimum investments, especially when compared to standard mutual funds and exchange-traded funds.
Alternative investments have limited verifiable performance data that can be used to advertise to potential investors. Despite their high initial minimum and high investment fees, alternative investments have lower transactional fees due to low turnovers.
Compared to conventional assets, alternative investments are fairly illiquid. For example, it would be more difficult to dispose of an ancient gold coin compared to selling shares. Due to the lack of regulation, alternative investments could be prone to fraud and investment scams. It is important for investors to conduct extensive due diligence when investing in alternative investments.
Traditionally, alternative investments targeted institutional and accredited investors. However, the investments have become accessible to retail investors through alternative funds.
Alternative Funds Strategies
The strategies alt funds employ are often complex. They include hedging and leveraging through derivatives. Other strategies include short-selling and opportunistic strategies that change with the market trends. Alternative mutual funds could be single-strategy funds or multi-strategy funds. Single-strategy alternative funds may employ a market-neutral or absolute return strategy that involves using long and short positions in stocks to realize returns. Multi-strategy funds employ a combination of strategies such as arbitrage strategies and market-neutral strategies.
The main objective of alternative mutual funds is to generate above-market returns. They also help investors manage risks better with strategies designed to smooth out the market and provide greater portfolio diversification.
The Unique Characteristics of Alternative Mutual Funds
If you are considering investing in alternative mutual funds, you should be aware of the unique characteristics of the funds and the risks of investing in them.
Unlike the standard mutual funds, alt funds generally achieve their investment goals by investing in non-conventional investments. For example, an alternative fund may invest in assets like start-up companies, global real estate, or commodities like oil or gold. These assets provide a more diversified portfolio. The alternative investments also provide different returns than more traditional investments like stocks, bonds, exchange-traded funds, and cash.
Alternative funds include a wide range of investment objectives designed to meet different investment needs. Many alternative mutual funds aim at minimizing the fluctuations in the value of their investments and reducing the risks. They achieve these goals by using complex trading strategies and spreading their investments among different assets. Some alternative funds seek to generate higher returns compared to standard mutual funds with a similar benchmark.
Investment and Trading Strategies
Alt funds pursue non-traditional strategies than conventional mutual funds. For example, an alt fund may use complex investment and trading strategies like using derivatives, selling stocks short, or following a “market neutral” or “absolute return” strategy. Fund managers combine different investment plans to seek positive returns even when stock markets fall. However, these strategies could result in additional risks and higher costs than traditionally-managed funds.
How Alternative Mutual Funds Compare With Hedge Funds
Some investment plans employed by alternative mutual funds are similar to those of hedge funds. Therefore, alt funds are often sold or marketed as a “hedge-fund-like” investment option for retail investors. Nevertheless, alt funds differ from hedge funds in several ways:
Alternative Funds are Regulated
As standard mutual funds, alternative funds are regulated under the Investment Company Act of 1940. This act provides several safeguards. The protections include restrictions on borrowing and debt, limits on illiquid investments, and the requirement to allow investors to dispose of their shares at any time. However, these regulations do not apply to hedge funds. Hedge fund managers are free to pursue non-traditional investment strategies and investments. Therefore, hedge funds are riskier than alternative funds.
Accessible to Retail Investors
Unlike hedge funds, alternative funds are open to the public, meaning any investor can invest in them. Hedge funds are only available to qualified purchasers or accredited investors. Accredited investors are high net worth individuals who meet certain minimum income or assets requirements. Therefore, hedge fund investors are financially sophisticated and can bear the risks that come with investing in them.
Lower Investment Fees
Investors in alt funds pay lower fees than those who invest in hedge funds. Many alternative mutual funds have an annual fee of 2% or less of the fund’s asset. However, investors in hedge funds pay an asset management fee of 2% and a performance fee of 20% of any profits earned from the investment.
Factors to Consider Before Investing in Alternative Mutual Fund
Alternative funds have unique characteristics and risks. Before you invest in alt funds, you should ensure that you understand all the characteristics and risks to determine if the investment is right for you. Below are some of the factors that you should consider:
· Investment Objectives
Different funds have different investment objectives. Some funds capitalize on management expertise in a certain area, such as investing in certain commodities. Other funds seek to provide diversification through exposure to foreign currencies, commodities, and other alternative investments. You should ensure that the alternative fund you invest in is in line with your investment goals.
· Strategy Risk Factors
Alt funds could have additional market and investment risks that are not common with traditional mutual funds. This is because, unlike traditional mutual funds, alt funds use relatively complex trading and investment plans. The risks vary depending on the strategy being used. Some of the additional risks that are common include the use of derivatives and leverage, short selling, futures contracts, and swaps.
· Operating Expenses
Alternative mutual funds may have higher operating expenses than the standard mutual funds. Alt funds pursue complex investment plans that require expertise and active management, leading to additional costs. The complex strategies may generate extra expenses.
· Minimum Investment
Many alternative funds have minimum investments. For example, a fund may have a minimum initial investment of $10,000 or higher. Others may require investors to have a net worth of at least $1 million before investing. Before you get started, you should ensure that you meet the necessary investment requirements.
The contents of alternative funds’ structures are not always clear because many of the funds do not have a clear legal structure. You should do your best to find out about a fund’s objective and holdings. Ensure that you also understand how a fund functions in the capital markets.
· The Fund’s Performance History
Before investing in a fund, you should understand how it has performed in the past. However, many alt funds have limited performance histories. Many alternative mutual funds were launched in 2008. It’s hard to tell how the funds would perform in a down market. The fund’s performance may be different from that of broad indexes like the S&P 500.
· The Fund Manager
When investing in alternative investments, it is crucial to gather ample information on the fund manager. How long has the fund manager been managing the fund? What is the manager’s previous management or professional experience? You can review the fund’s prospectus to gather information about the fund manager.
Alternative Investments for Portfolio Diversification
There is a low correlation between alternative investments and standard asset classes. This low correlation means that alternative assets move in the opposite direction to stock and bond markets. This makes the assets suitable for portfolio diversification. Investing in non-conventional assets like oil, gold, and real estate provides a hedge against inflation. Therefore, many institutional funds like private endowments and pension funds allocate a portion of their portfolio to alternative investments.
The non-accredited investors have access to alternative investments through alternative mutual funds and ETFs. Because alternative mutual funds are publicly traded, they are registered under SEC and regulated by the Investment Company Act of 1940. An alt fund makes it easy for retail investors to invest in alternative assets that were previously costly and difficult for an average investor to access.
Alternative funds are not for all investors. They have high market risk, a high minimum investment, and high expenses. If you seek to diversify your investment portfolio, you can do so by investing in different categories, assets, and capitalization. You can also invest in focused areas like industrial sectors. You can include mutual funds or ETFs that incorporate alternative securities or strategies into your portfolio. Whatever strategy you adopt, always ensure that you do your research before investing.