Alternative mutual funds have exploded in popularity in recent years. But there is a dark side to alternative mutual funds. Last week, the Financial Industry Regulator (FINRA) warned investors about this very issue, cautioning them in an Investor Alert titled “Alternative Funds Are Not Your Typical Mutual Funds.” Among other things, the alert stressed the complex trading strategies and the unique characteristics and risks associated with alternative mutual funds.
“The strategies alternative mutual funds employ tend to fall on the complex end of the spectrum,” FINRA said in its Investor Alert. “Examples include hedging and leveraging through derivatives, short selling and ‘opportunistic’ strategies that change with market conditions as various opportunities present themselves.”
As their name implies, alternative mutual funds are quite different from their traditional counterparts. Alt funds typically use more exotic strategies, including options and leverage, as well as more complex asset mixes. Alternative funds might invest in assets such as global real estate, commodities, leveraged loans, start-up companies and unlisted securities that offer exposure beyond traditional stocks, bonds and cash.
Some alt funds employ a single strategy. For instance, they may offer 100% exposure to currencies or distressed bonds. Some funds might employ a market-neutral or “absolute return” strategy that uses long and short positions in stocks to generate returns. Others may employ multiple strategies such as a combination of market-neutral strategies and various arbitrage strategies. Still others are structured as a fund containing numerous alternative funds or a special type of “fund of hedge funds,” according to FINRA.
Although the strategies and investments of alternative funds may appear similar to those of hedge funds, the two should not be confused, FINRA says. Alternative mutual funds are regulated under the Investment Company Act of 1940, which limits their operations in ways that do not apply to unregistered hedge funds. These protections include limits on illiquid investments; limits on leveraging; diversification requirements, including limits on how much may be invested in any one issuer; and daily pricing and redeemability of fund shares.
FINRA cautions investors who are considering investing in alternative mutual funds to carefully consider their investment objectives, performance history and fund manager of alternative funds before doing so.