By Hal M. Bundrick

With the stock and bond markets in choppy waters, investors have been searching for life boats: an investment with an income component and upside potential. Alternative mutual funds -- or "alt" funds -- have been touted as just such a solution. These funds allow exposure to global real estate, commodities, leveraged loans, unlisted securities and other non-traditional assets, but may also put investors into deeper water than they expected.

The Financial Industry Regulatory Authority (FIRNA) is raising a warning flag in the form of an Investor Alert on alt funds in an effort to make potential investors more aware of the unique characteristics and risks of alt mutual funds.

"Investors should fully understand the strategies and risks of any alternative mutual fund they are considering. FINRA is warning investors to carefully consider not only how an alt fund works, but how it might fit into their overall portfolio before investing," said Gerri Walsh, FINRA's Senior Vice President for Investor Education.

On the surface, these mutual funds seem appealing enough, providing exposure to expanded asset classes beyond typical stocks and bonds. The funds also use advanced trading strategies, such as hedging and leveraging through derivatives and short selling. Some are layered "funds of funds." While similar in some ways to hedge funds, alt funds are regulated under the Investment Company Act of 1940, unlike hedge funds.

FINRA's investor alert reminds investors to consider the distinctive features of alt funds before investing:
  • Investment Structure: An alternative fund of funds may offer greater diversification than a single-strategy or even multi-strategy alt fund. At the same time, this greater diversification may lead to a flattening of return and potentially less transparency. There may also be an inability to re-allocate or adapt in a way that is beneficial to the overall performance of a particular fund of funds.
  • Strategy Risk Factors: In addition to the usual market and investment specific risks mutual funds have, alt funds carry additional risks from the strategies they use. For example, market-neutral funds tend to have significant portfolio turnover risk that can result in higher costs. Similarly, a distressed bond fund is likely to have significant credit risk.
  • Investment Objectives: One fund might be designed to capitalize on management expertise in a specific area (investing in distressed companies, for instance). Another might seek to provide what the fund's managers believe to be more complete diversification through exposure to commodities, currencies and other alternative investments.
  • Operating Expenses: Alternative mutual funds can be pricey relative to their traditional managed fund peers. It is common for alt funds to have annual operating expenses of around 1.5 percent per year, and some funds are considerably more expensive.
  • Fund Manager: Learn as much as you can about the fund manager, such as how long they have managed the fund and additional fund management or professional experience. Research the professional background of a fund manager using FIRNA Broker Check
  • Performance History: Many alternative funds have limited performance histories. For example, a fair number were launched after 2008, so it is not known how they will perform in a down market. They may underperform broad indexes such as the S&P 500--particularly after considering expenses.

--Written by Hal. M Bundrick