Retail Investors Embrace Alternative Funds to Battle Volatility

When it comes to managing their finances amid the stock market’s wild swings, instead of stashing cash under their mattresses investors are starting to think more like hedge fund managers.

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A slew of “alternative” mutual funds has cropped up, enabling individual investors to dabble in short, ultra-short, long-short, market-neutral and other strategies once reserved largely for hedge funds and other institutional investors.

The trend started taking off in 2006, but has gained momentum in the wake of the 2008 financial meltdown that followed the collapse of Lehman Brothers.

“What investors found out in 2008 was that in times of crisis, credit risk and equity risk are highly correlated,” says Nadia Papagiannis, alternative investments strategist with mutual-fund researcher Morningstar

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[MORN  Loading...      ()   ] in Chicago. “They recognized the need for a different strategy to diversify outside of traditional stocks and bonds.”

There are currently around 644 alternative-style funds — 251 mutual funds and 393 exchange-traded funds , which are mutual funds that trade like stocks, according to a Morningstar tally.

So far in 2011, there have been 249 ETFs , of which 90 (or 36 percent) were alternative and commodity ETFs and there have been 333 new mutual funds, of which 48 (or 14 percent) were alternative and commodity funds.

The most common funds are “long-short,” which can buy stocks or go “short” (which is the practice of borrowing a stock and selling it in hopes of buying it back later at a cheaper price and pocketing the difference).

Also popular among the so-called hedge fund clones is “market-neutral” funds, which aim to make money under all conditions and give zero market risk by balancing long and short positions.

Investors can also dabble in merger or “arbitrage” funds, which bet on corporate takeovers, as well as on options, currencies and commodities among others.

Because of their low correlation in movements to traditional investments in stocks and bonds, alternative investments are viewed as a “hedge” to help protect portfolios during sideways or down markets.

“What we use alternative strategies for is mostly to smooth out peaks and valleys,” says Louis P. Stanasolovich, a financial planner and president of Legend Financial Advisors in Pittsburgh. “Sometimes you can gain an edge, but for the most part it’s for smoothing out whenever possible.”

Indeed, investors shouldn’t be hoping for outsized, hedge fund -like returns from their alternative mutual fund investments, many of which have been offering up poor returns over the past few years.

“They’re doing well in terms of protecting the downside,” says Morningstar’s Papagiannis. “But some are not doing so well in capturing the upside. That’s their biggest problem so far, on average.”

A survey by Morningstar early this year found that of the 73 percent of financial advisors using alternative investment vehicles for their retail or high net worth clients, typically between 6 percent and 10 percent was allocated to such investments.

More than half of advisors surveyed expect to see those allocations increase by more than 10 percent a year over the next five years.

While a 10-percent allocation might be the norm now, some market observers think it wise to boost the portion devoted to alternative investments closer to 40 percent. That’s long been a typical level for pension funds, university endowments and other institutional investors, which have the ability to take on illiquidity risk such as investing in private equity.

“I’m in the 40 percent camp,” says Papagiannis, who is 33 and hasn’t had much luck with stocks since getting into the market after the crash of 2002. “A lot of advisors tell me I should be in growth stocks at my age, but I don’t think the market’s going to go anywhere for a while. I don’t want to lose money.”