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Alternative Funds Enter the Mainstream

Now some are seizing on alternative funds as a way to deliver the protection that clients seek. "The old answers from advisers don't cut it anymore," said Cortez. "Advisers need to be able to explain what they are going to do if the market gets into trouble."

The alternative funds do not represent panaceas. Many of the funds charge stiff expense ratios of more than 2.0%, and the funds tend to lag in bull markets.

Consider market-neutral funds. When stocks sank in 2002, market-neutral funds looked like heroes, returning 5.0% for the year and outdoing the S&P 500 by 27.1 percentage points. Then for the next five years, the S&P 500 rallied, and market-neutral funds lagged behind, generating modest single-digit returns.

Proponents say that alternative funds are attractive because they can deliver modest results consistently, helping portfolios stay in the black during downturns. "All investors should have alternatives in their portfolios," said Nadia Papagiannis, a Morningstar analyst who spoke at the alternative fund conference. "Anything that can help you to diversify is good."

Finding sound alternative funds can be difficult. Most funds have short track records. Investors who have never tried alternative funds should stick with proven managers.

A top market-neutral choice is Merger Fund (MERFX), which has returned 4.3% annually during the past five years, compared with a return of 2.9% for the S&P 500.

The fund employs merger arbitrage, buying shares of companies that are about to be acquired. Sometimes it shorts the stocks of acquirers.

A long-short fund with a compelling track record is Caldwell & Orkin Market Opportunity (COAGX), which has returned 5.7% annually for the past five years. Portfolio manager Michael Orkin has been running the fund since 1992.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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