NEW YORK (TheStreet) -- Managed futures mutual funds emerged as one of the stars of the financial crisis. While the S&P 500 lost 37% in 2008, managed futures funds gained 8.3%.
The strong showing attracted attention. Seeking protection, shell-shocked investors poured into managed futures and other mutual funds that are considered alternative investments. The category includes a variety of strategies that do not necessarily move in lockstep with stocks or bonds. Common approaches involve holding precious metals or selling securities short, betting that they will decline.
At a time when many investors remain wary of stocks, alternative funds have ranked as the fastest-growing category tracked by Morningstar. Assets have increased from $62 billion at the end of 2008 to $179 billion now. But most alternative funds have proved disappointing. While the S&P 500 returned 19.9% annually during the past five years, managed futures lost 4.6%.
Morningstar analyst Adam Zoll says that most alternative funds have failed in their primary mission of providing diversification. To determine which investments can diversify stock portfolios, Zoll measured the correlation of different assets and the S&P 500. If an asset moves in lockstep with the index, then it is said to have a correlation of 1.0. If the asset moves in the completely opposite direction of the index, then it has a correlation of -1.0.
To provide diversification, an investment must have a low or negative correlation with stocks. The investment-grade bonds of the Barclays Capital Aggregate U.S. Index can provide diversification because they have a correlation of 0. Many alternative funds record high correlations. With a correlation of 0.95, long/short funds may provide little cushioning when stocks sink.
Should you avoid alternative funds altogether? Not necessarily. But you need to shop carefully.
Many funds are hard to understand and charge steep expense ratios. Only a few alternative funds have provided diversification and solid returns. Top choices include MainStay Marketfield (MFLDX - Get Report) and Wasatch Long/Short (FMLSX). During the past five years, both funds delivered double-digit annual returns while being much less volatile than the S&P 500.
To try a dose of alternatives, consider Aberdeen Diversified Alternatives (GASIX - Get Report), which invests in a portfolio of about 15 mutual funds. The Aberdeen managers aim to provide protection in downturns and deliver some gains in bull markets. Most often the approach has worked. During the past five years, Aberdeen returned 13.5% annually and ranked as the top-performing multialternative fund. The Aberdeen portfolio managers have 9.9% of their assets in MainStay Marketfield. Other holdings include AQR Managed Futures (AQMIX - Get Report) and Arbitrage Event-Driven (AEDNX - Get Report).
Among the steadiest alternative funds is Calamos Market Neutral Income (CVSIX - Get Report). It is focused on income and capital preservation. The fund has delivered a five-year annualized return of 7.13%, according to Morningstar.
Calamos may be particularly appealing for investors who seek to diversify bond portfolios. Bonds tend to sink in periods of rising rates. But the Calamos strategy can stay in the black during most market environments. "Investors come to us because they do not want surprises," says Calamos portfolio manager Chris Hartman.
Calamos invests part of its assets in a strategy known as convertible arbitrage. To implement the approach, the managers first buy convertibles, bond-like instruments that can be converted to stocks. Then the managers sell short the stocks of the convertible issuers. If the stocks fall, the convertibles could suffer losses. But the fund can stay in the black because the short sales should generate profits. If stocks rise, the convertibles will climb enough to compensate for the short positions, which should generate losses. The approach sank into the red when convertibles collapsed in the turmoil of 2008. But since then, the Calamos fund has delivered consistent returns.
At the time of publication, the author held no positions in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.