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Hedge Funds for the Average Investor

Money in Mattress
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Money in Mattress

Alternative assets are a good diversification tool because they're generally not correlated to the stock market.

This means when the market goes down, alternative assets may go up or stay the same and vice versa.

Large investors such as pension and endowment funds have been attracted to hedge funds because of their reputation for producing high returns.

But it's difficult to tell how successful hedge funds are because the historical data leaves much to be desired.

"They are self-reported. Indexes of hedge fund performance are biased by the fact that those that do poorly go out of business and those that do well stay in business," says Walt Woerheide, Ph.D., CFP, vice president of academic affairs and professor of investments at The American College in Bryn Mawr, Penn. "And so when you look at the index over time, it's really an index of those that have done well."

Though people refer to hedge funds as a single category of investment, they actually follow different strategies that try to beat the market.

"One may engage in bankruptcy situations. Another may be involved in merger and acquisition opportunities. The variety of strategies that hedge funds follow is all over the place. It's not a homogenous type of investment," says Woerheide.

Alternative Investing - A CNBC Special Report - See Complete Coverage
Alternative Investing - A CNBC Special Report - See Complete Coverage

Like actual hedge funds, hedge-like mutual funds also follow various strategies, but they are much more transparent and less controversial than their brethren.

In general, they're more expensive than other stock funds, charging 2.04 percent a year on average, versus 1.47 percent for actively managed stock funds and 0.78 percent for equity index funds, according to Morningstar. Some hedge-like mutual funds cost as much as 3.89 percent, and a couple cost more than 5 percent annually.

That's cheap compared to real hedge funds, though.

"They get something like a 2 percent fee and then 25 percent of the profits if they make money. And then nothing happens if they lose money," says Woerheide.

Albert Chu, chief investment officer for Wealthstone in Columbus, Ohio, believes that getting exposure to the asset class is worth the fees in some cases.

"We index our large-cap managers since they tend not to outperform and with those savings we're going to allocate some fee dollars to some of our alternative strategies," he says.

Should you choose to dabble in these alternative investments, be sure to investigate them thoroughly or get some good advice from a trusted adviser.

Long-short funds

According to investment research company Morningstar, about 75 mutual funds employ hedging strategies.

"The easiest example of an alternative strategy is going to be a long-short fund or opportunistic equity," says Chu, a chartered financial analyst and chartered alternative investment analyst.

A long-short strategy involves investing in stocks with positive prospects (making long bets) as well as stocks that are expected to decline in value.

"If a portfolio manager has a group of stocks, they're going to go out there and buy their best ideas and hope they rise in value. And that is a long (bet)," Chu says.

Then if they find some challenged companies, the fund managers will short those companies and put together a long-short portfolio.

Here's how short-selling works: The investor can use leverage, by borrowing money on margin from his broker, to borrow the stock at a certain price and sell it to someone else. When the stock price drops, the investor buys the stock at market price, gives it back to the broker and pockets the profit.

Short-selling is a highly risky strategy, because if a stock goes up instead of down as expected, the investor's potential for loss is unlimited.

Long-short funds are the most widely available hedge strategies in mutual funds, and most don't require big minimum investments.

"You're going to have a different return pattern than the overall stock market," says Chu.

Recent history bears this out. Long-short funds outperformed the S&P 500 during the 17-month bear market that ended March 9, 2009. The hedge-like mutual funds lost 15 percent on average while the broad market plummeted 43 percent.

Long-short funds also haven't rebounded as much either. Since March 10, the S&P gained 50 percent through mid-August, while long-short funds advanced 16 percent.

Commodities

Commodities also may be a good alternative option for the individual investor's portfolio.

"Commodities are worth considering not for returns but because they act like portfolio insurance. By themselves they're very volatile, but when you add them to a portfolio, the historical evidence is that you reduce the risk of the portfolio and get higher risk-adjusted returns," says Larry Swedroe, principal and director of research at Buckingham Asset Management in St. Louis.

That wasn't particularly the case in the most recent bear market, though. According to Morningstar, most commodity indexes did worse than the S&P 500 in 2008, which was down 37 percent for the year. For instance, the natural resources category, which includes gas and oil, took a 48 percent hit.

Swedroe, author of "The Only Guide to Alternative Investments You'll Ever Need," particularly recommends commodities in the form of fully collateralized commodity futures.

Fully collateralized means unleveraged. Commodity futures are speculative financial instruments known as derivatives that are financial contracts written on the future price of a product.

Just like with equities, some commodity funds use long-short strategies in an effort to improve returns. Some commodity funds are actively managed, while other ETFs and mutual funds follow commodity indexes.

Multistrategy funds

Mutual Funds
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Mutual Funds

A few fund companies offer products with a number of different strategies in one absolute return product, called a multistrategy mutual fund.

As a mutual fund, the way it works is that the manager sets up different accounts as a custodian. All of those accounts together would be contained in one mutual fund.

They're "just different alternative strategies combined into one. What they try to do is target equity-like returns and bond-like volatility," says Chu.

Individual investors looking for alternative investments might rather go with a multistrategy fund than a long-short fund, Chu says. "You probably want to go with a multistrategy fund-of-funds mutual fund."

Some of these funds have somewhat prohibitively high minimums, but others can be reasonable for anyone.

"We use those alternative mutual funds in our own 401(k) here at Wellstone, and we also recommend that for other 401(k) plans that we administer," says Chu.

"In the end the manager selected may not be as, I don't want to say 'good,' but may not be the best manager out there," he says. "But again, it goes back to the fact that it is more important to get the asset classes correct since we know over time that tends to add more value than manager selection."