Alternative Mutual Funds: The Good and the Bad

By Becky Clapes, Spring 2017 Guest Blogger

The SEC’s Office of Investor Education and Advocacy has recently released an investor bulletin about alternative mutual funds. An alternative mutual fund, also known as an alt fund or liquid alt, is a non-traditional and complex investment. The SEC issued the alert to ensure that investors are aware of what these investments are and the risks that might come with them.

The SEC recommends that investors do their homework and “read the funds’ prospectus and shareholder reports” that can be found in the EDGAR database.  But researching and reading reports isn’t enough.  Investors should be aware of the risks that come with these investments and think about how they might impact them.

Alternative mutual funds do possess specific risks to be considered before choosing to invest. Because of the complex investment strategies alt funds utilize, they face risks such as use of derivatives and leverage, futures contracts, short selling, and swaps. Additionally, alt funds often have higher operating expenses than a traditional mutual fund because their complexity requires more specific expertise and time. Finally, because many alternative mutual funds were created after the 2008 market crash, it is uncertain how they will perform in a down market.

Investors should also know why alternative mutual funds operate as they do.  Some objectives of alt funds include: minimizing swings in value of investment, reducing risk through diversifying investments, and seeking above-market returns as compared to other mutual funds. Alternative funds invest in “non-traditional assets” such as real estate, start-up companies, or commodities like gold and oil. Compared to hedge funds, alternative mutual funds have similar investment strategies and may be marketed similarly; however, there are several differences between alt funds and hedge funds. Alt funds are regulated by the Investment Company Act of 1940, providing certain safeguards such as limits on illiquid investments, restrictions on borrowing and debt, and requiring investors be allowed to sell shares at any time. Hedge funds are not regulated by the Act and are therefore not required to follow these regulations. Additionally, while hedge fund shares may only be purchased by qualified purchasers with a minimum level of income/ assets, anyone may purchase shares of alt funds.  Finally, alt fund investors typically pay lower fees than hedge fund investors.

As with any investment, be sure that you are an informed investor.  Do your homework, know what you are buying, and know how it fits into your investment plan.