Alternative funds are taking center stage

Andrew Osterland, special to CNBC.com

With the stock market careening wildly of late, it's no surprise that investors are looking for alternatives.

Nearly $4 billion flowed into alternative investment funds — often called liquid alt funds — in July, August and September, according to data from research firm Morningstar, and they have had nearly $10 billion in net inflows since the beginning of the year. The funds invest in a wide range of asset classes and use hedge fund–like trading strategies with the objective of producing returns not closely correlated with stocks or bonds.

Caiaimage | Martin Barraud | Getty Images

"The attraction of alternative funds is related to where the [traditional] asset markets are," said Ihor Szeremeta, managing director of U.S. Wealth Advisory Alternative Investments for BlackRock. The firm launched its first long/short equity fund four years ago and now has 10 publicly traded funds it characterizes as alternative.

"It's when things are unclear and other risks in a portfolio aren't working well that investors count on alternatives to work for them," he said.

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So far, they appear to be delivering on the promise. Between mid-August and mid-September, the global MSCI index fell about 8 percent, while the BlackRock Global Long/Short Equity Fund that invests in and shorts global stocks was down 0.94 percent. "That's a successful outcome and a benefit to have in your portfolio," Szeremeta said.

There were currently more than 1,500 publicly traded alt funds managing $165 billion in assets at the end of September. Late last year it appeared that investors had finally tired of the high fees and poor performance of alt funds relative to both stocks and bonds, according to industry observers.

We think alternative strategies have the potential to reduce risk and broaden asset exposures, but they only make sense as part of a broader portfolio.
John Ameriks
principal and head of quantitative equity group at Vanguard

For the first time since the financial crisis, there were net outflows from the overall category at the end of 2014. Investor interest, however, has ramped up again, with the rise in volatility in the stock market.

So far this year, the hottest tickets are the multi-alternative strategy funds that combine a variety of alternative investing strategies and managed futures funds that typically follow trends in commodity and currency prices.

Between them, they've taken in more than $17 billion so far this year, more than making up for big outflows from formerly popular categories, like long/short equity funds and market neutral funds.

"The space is so new that you see a lot of performance chasing," said Morningstar analyst Jason Kephart. "The flows are exaggerated, going up and down."

After a long period of underperformance following the financial crisis, the managed futures funds have benefited from strong trends in commodity prices — most notably oil — and in currency movements (i.e., the strong U.S. dollar). The largest such fund, the AQR Managed Futures Strategy Fund, manages $9.6 billion in assets.

The multi-alternative funds combine various alternative strategies, often shopping out the management of assets to sub-advisors. The category has attracted more than $10 billion in assets this year despite all-in costs that sometimes exceed 3 percent.

"We tell investors never to invest in things they don't understand," Szeremeta said. "These funds have to be assessed individually, and investors have to think about them in the context of their overall portfolio."

Alternative funds have been a godsend for the fund companies.

With an average management fee of almost 1.8 percent, alt funds have been one of the few fund categories to preserve a higher margin as the market has shifted to lower-cost passive indexing strategies.

"Studies have shown that alternatives have been the only fund category where fees haven't declined significantly," said Morningstar's Kephart.

Vanguard, the low-cost conscience of the fund industry, could change all that. Its low-cost indexing model laid the foundation for the massive shift to passive investing and delivered a big hit to profitability in the fund-management industry. If Vanguard enters the alternative funds business, it's going to compete on price.

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"The Vanguard value proposition is to deliver both active and indexing products to investors at the lowest possible cost," said John Ameriks, principal and head of Vanguard's quantitative equity group. "We have more work to do with alternatives."

The giant fund manager currently has only one 40 Act mutual fund employing alternative investing strategies, and it is combined with other strategies in the firm's $1.6 billion Managed Payout Fund that was launched in 2008.

That fund targets endowments and retirees with an objective of paying out 4 percent of assets annually. Ameriks said the firm currently has no plan to market stand-alone alternative funds to retail investors.

"Anytime we see a category explode and products proliferate rapidly, we'll be deliberate about how we get involved," he said.

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Cost isn't the only concern for Amerik. He also thinks that investors are chasing returns and not using alternatives in a deliberate manner to reduce risk in their overall investment portfolios.

"We think alternative strategies have the potential to reduce risk and broaden asset exposures, but they only make sense as part of a broader portfolio," Ameriks said. "We want investors to understand what we're offering them."

He added, "It's a question of when there's enough understanding of these funds that they can be used effectively by investors. We don't see it now."

The erratic flows among fund categories would certainly suggest that. While investors may understandably be looking for alternatives in this volatile environment, they may be sorely disappointed if they go looking for quick fixes among liquid alt funds.

"The dispersion of returns in this fund category is huge," said Kephart at Morningstar. "The worry is that investors are chasing where the puck was instead having a long-term allocation to the funds."

By Andrew Osterland, special to CNBC.com