Alternative investment strategies that were once the domain of institutional and high-net-worth investors are going mainstream.
Indeed, fund companies are responding to demand for downside protection in the wake of the 2008 market collapse with a new lineup of liquid alternative products.
Such funds, which are sold as both mutual funds and exchange-traded funds, seek to stabilize portfolios by delivering differentiated returns. Meaning, the funds are designed to zig while the traditional stock and bond markets zag.
The more than 400 liquid alternatives that exist, many of which are fewer than five years old, invest in nontraditional assets, such as global real estate, leveraged loans, start-up companies and unlisted securities.
They also utilize complex trading strategies commonly associated with unregistered hedge funds and private equity funds, including long/short equity, managed futures, market neutral, multi-alternative, multicurrency and nontraditional bonds.
Unlike hedge funds, however, liquid alternatives, which are also called 40 Act funds for the act of Congress that created them in 1940, have no income requirements. They can also be bought and sold daily through the stock exchange, making them both liquid and accessible to average investors.
"We've seen a resurgence in the mutual fund space by retail investors looking to diversify towards alternative solutions with better liquidity," said Josh Charney, an alternative-fund analyst with investment research firm Morningstar.
Assets under management in liquid alternative products reached $279 billion as of Sept. 30, up from $68 billion in 2008, according to Morningstar. For its part, consulting firm McKinsey & Co. estimates that alternative mutual funds will account for 13 percent of all mutual fund assets by 2015.
The momentum behind 40 Act funds has been fueled in part by financial advisors, who increasingly rely on noncorrelated assets to minimize risk and boost return for their clients. Correlation is the degree to which an asset moves in the same direction as stocks and bonds.
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A 2013 Morningstar study found that mutual funds are becoming the dominant vehicle used by both financial advisors and institutions to access alternative strategies. Similarly, only 4 percent of advisors said their typical client had no money in alternative investments, down from 17 percent in 2008.
"A lot of advisors suffered through the tech wreck [from 2000 to 2002] and then the global financial crisis in 2008, so they really understand the need for diversification inside their clients' portfolios," said Matt Osborne, executive vice president and managing director of strategic initiatives with Altegris Investments.
The advent of liquid alternatives inside a mutual-fund wrapper, he said, has not only changed the way alternative investments are bought and sold but given investors the stability they need to resist knee-jerk reactions with their portfolios.
It was nearly impossible in 2008 for advisors to convince clients to stay invested when portfolios were down 50 percent. "But if they can smooth the ride by diversifying into alternatives, it makes it easier for their clients to withstand volatility in individual investments," said Osborne. "If only part of their portfolio is exposed, they can stay the course when equities are down," he added.
Liquid alternatives are also perceived as a port in the storm in the current market environment, said David Lafferty, senior vice president and investment strategist at Natixis Global Asset Management.
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"There is a recognition from investors that the three basic asset classes they're used to dealing with all have structural headwind," he said, noting equities have become more volatile, while fixed-income securities are delivering lackluster yields with the threat of higher interest rates ahead. Cash equivalents, like money market funds and short-term government bonds, are also generating a negative real return after accounting for inflation.
"These three asset classes still need to be part of your core portfolio, but investors are looking for alternatives that can offer reasonable levels of return with a reasonable level of risk," said Lafferty.
Look before you leap: Like all investment products, however, liquid alternatives have both pros and cons.
Some, for example, have struggled to capture upside gains in the current bull market, making them less attractive for those who believe the equity rally will continue, said Morningstar's Charney.
"You have to get into it for the right reasons," he said. "If you're worried about downside risk, there's never a wrong time to make a prudent diversification move. But if you're worried about missing out on upside potential, you might want to stay in the equities market."
Investors who wish to hedge market risk but also maintain equity exposure, he added, could split the difference and opt for a long/short equity fund, in which the fund manager goes "long" on (buys) stocks he thinks will rise in value and sells short securities he expects will fall. Such funds tend to have near equity returns, he said.
Although the strategies and investments of liquid alternatives mimic those used by nonregistered alternatives, the Financial Industry Regulatory Authority (FINRA) also notes they have diversification requirements and leverage limits that hedge funds do not.
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Thus, they are not a direct replacement for hedge fund investors.
"Everyone is running from illiquidity after 2008, but if you say all alternative strategies are the same, you're going to push too much money at a group that may not have the same advantages as the illiquid ones," said certified financial planner Leo Kelly, founder, CEO and managing director of HighTower Kelly Wealth Management. Hedge funds and private equity funds typically limit the amount investors are allowed to withdraw during a redemption period, but they also pay a premium for the lack of liquidity, he said.
Check the fees: Due to their complexity, liquid alternatives also require active management, so their fees tend to be higher than their traditional managed-fund peers.
Market-neutral funds, in particular, which seek to profit from both increasing and decreasing prices within the same sector or market, have significant portfolio turnover risk that may result in higher costs, FINRA notes.
And many multistrategy funds have average expense ratios of 2 percent or more, according to Charney.
By comparison, the average expense ratio for actively managed mutual funds is roughly 1.5 percent.
Keep it simple: Investors who are looking to allocate into liquid alternatives should carefully consider the fund's investment structure and the specific risk it is trying to hedge, according to FINRA.
Managed futures funds, for example, seek to deliver diversification benefits by owning assets with a low correlation to the markets, including but not limited to commodities. Multicurrency funds typically bet against the U.S. dollar by investing in a broad basket of foreign currencies.
And nontraditional bond funds aim to provide income protection against rising interest rates through the use of fixed-income derivatives and other unconventional tactics.
Most average investors, however, would be best served with a multistrategy fund, said Lafferty, which delivers broad exposure to a diversified portfolio of hedge fund–like strategies.
"For someone just dipping their toe in, a multistrategy fund makes it simpler to access alternative strategies without having to understand all the nuances of the underlying portfolio," he said, noting investors need to consider the expertise of the fund's management team.
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How much is too much? The Morningstar survey found financial advisors recommend an allocation of between 6 percent and 20 percent to liquid alternatives.
Alternative investment strategies that are packaged into traditional products, like mutual funds and ETFs, have leveled the playing field for managing market risk.
However, while the asset class is likely to play an increasingly pivotal role in the average investor's portfolio, very few 40 Act funds have had the chance to prove themselves through a market crisis.
"Advisors are becoming more comfortable recommending liquid alternatives, but these funds are going to have to live up to the diversification, performance and risk promises to stay top of mind with investors," Lafferty said.
—By Shelly K. Schwartz, Special to CNBC.com