The Financial Industry Regulatory Authority (FINRA) recently issued a warning to investors about alternative or “alt” mutual funds. Such funds use investment strategies that differ from mutual funds’ typical buy-and-hold strategy. Rather, alternative funds often hold non-traditional investments and use more complex trading strategies. Due to the more complex and riskier nature of these funds, alternative fund investors are more likely to stockbroker misconduct or investment fraud victims.
Alternative funds invest in things such as global real estate, commodities, leveraged loans, start-up companies, and unlisted securities, all of which can be far riskier than many publicly traded stocks and bonds. The funds also engage in more complex strategies, such as hedging and leveraging through the use of derivatives and short selling. And some alternative funds even invest in other alternative funds.
Due to the often-risky nature of alternative funds, investors should be especially careful when making such investments. Some of the things investors should consider are:
Strategy Risk Factors: In addition to the usual market and investment specific risks associated with mutual funds, alternative funds also involve risks based on the strategies they use. For example, market-neutral funds tend to have significant portfolio turnover that can result in higher costs. Such costs make it more difficult for the fund to be profitable.
Operating Expenses: Operating expenses for alternative funds can be significantly higher than the operating costs for the typical mutual fund. These operating costs create another hurdle that alternative funds must overcome before they are profitable for investors.
Performance History: Many alternative funds have limited performance histories. Many were launched after 2008, so they have not experience a down market. As such, there is no historical data to see how they have performed in a down market.
As with all other investments, investors should do their homework before investing in an alternative fund. It is important to ask questions and only invest after you have reached a comfortable level of understanding of the product. And even then, you should not allocate too large a percentage of your investment portfolio to any single investment product.