NEW YORK ( TheStreet) -- Alternative funds once represented a small niche in the mutual fund universe, but that is changing.During the past year, inflows have totaled $25 billion into alternative mutual funds and exchange-traded funds, according to Morningstar. Now the category has $151 billion in assets and includes 540 funds. Morningstar recently announced that it would begin tracking new categories of alternative funds, including inverse debt and managed futures. "It's clear that alternative funds are here to stay," said John Rekenthaler, vice president of research for Morningstar. Alternative funds aim to diversify portfolios by focusing on investments that don't necessarily track stocks or bonds. The funds hold commodities or use complicated strategies, such as trading futures or selling stocks short. In the past, many financial advisers avoided alternative funds, viewing them as expensive investments that could produce only meager results. But the downturn changed attitudes. During 2008, market-neutral funds, which hold long and short positions, stayed in the black, outdoing the S&P 500 by 37 percentage points. Seeing the results, some advisers embraced alternatives in order to serve clients who had been traumatized by losses. These days more advisers are demanding alternative funds, said Rick Cortez, president of distribution for Broadmark Asset Management, which manages Forward Tactical Growth ( FTAGX), a long-short fund. He said that angry clients are asking tough questions, demanding to know how advisers plan to protect portfolios if the market sinks again. Cortez spoke at a recent conference on alternative funds that was sponsored by several fund companies, including AQR Capital Management, Eaton Vance Investment Managers, Forward Funds, and JP Morgan Funds. Speakers at the conference said that pension funds and university endowments have long relied on alternative investments. The growth of mutual funds aimed at retail investors has only occurred in the last several years. So far, do-it-yourself investors have been wary of the new mutual funds, but a growing number of financial advisers have been steering clients to alternative strategies. This represents a major change. Most advisers have long been committed to traditional strategies, urging clients to hold plain-vanilla stock funds throughout downturns.
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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