What if the best stock to own for the next year isn't a stock at all?
That's the question that alternative funds are making investors ask themselves in 2015 -- and after a year of grinding sideways performance, it's not surprising that billions of dollars are getting dumped into other options this year.
The good news is that while alternative strategies were once limited to the wealthiest, most sophisticated investors, an increasing number of alt options are coming online for regular individual investors to take advantage of.
So should alternatives make up a bigger chunk of your portfolio this fall? Today, we'll take a look at some of your best options in this investment space.
A Quick Primer on Alternative Investments
Common types of alternative funds include real estate, managed futures, long/short equity funds and hedge funds.
And generally speaking, alts have been one of the hottest places to park your cash in the past year. According to data compiled by fund tracking firm Morningstar, alternatives have taken in an estimated $10.1 billion in assets over the last year, a stretch when U.S. stocks have actually shed an approximately $7.4 billion in flows.
You might be wondering why you should have any interest in alternative investments at all, considering the fact that the big S&P 500 stock index hasn't actually posted a meaningfully down year since all the way back in 2008. In other words, despite a mostly sideways 2015, conventional investments are still working pretty well in the long-term.
But the reason that alternatives can add value to your portfolio has to do with correlations.
You see, when times get tough (like they did back in 2008), market correlations spike, and all conventional assets tend to move together. Professionals seek uncorrelated investments because they can actually provide some strong performance during periods when most other investments are sliding. Likewise, when the market is moving sideways (as it has been this year), uncorrelated investments can often still generate positive absolute returns.
How do you generate returns that are uncorrelated with the rest of the market? There are two ways: You can either own things that most stock investors don't (such as private companies or commodities), or you can use a strategy that most stock investors don't (like a long/short fund or managed futures fund would).
Should alternatives make up the majority of your portfolio right now? No, probably not. Not only do alt funds typically come with higher fees, but we're also in an environment where conventional stock investors are faring pretty well overall. Instead, think of alt funds as a valuable complement to your core stock holdings.
What You See Isn't Always What You Get
Before we delve into some alternative funds you can buy today, there's one more important factor to consider when weighing alternative funds: What you see isn't always what you get. By that, I mean that just because a fund claims to be an alternative investment doesn't mean that it will perform like one.
For instance, while most investors think of real estate investment trusts as a great way to get exposure to real estate, the reality is that huge dividend yields make them much more interest-rate-sensitive than actual real estate.
And it's important not to pay a large premium to funds that simply own a big collection of investments that you could go out and buy yourself. Save the fees and build your own basket of REITs, for instance.
Finally, don't chase returns. Returns are cyclical, which means that typically, the funds or strategies that return that highest returns in a given year tend to underperform in the periods that follow. That's not just true of alternatives; it's also the case with pretty much any fund category.
With all that in mind, there are some solid alt funds that you can buy today. Here's a look at 10, split up by some common categories.
Managed Futures Funds
Up first are managed futures. Managed futures funds use futures contracts to invest in big pervasive trends. Since the futures markets can provide access to assets like commodities, which are difficult for retail investors to trade directly, they tend to have very low correlations with the rest of the market. So does the technical trend-following strategy that these funds typically use. And that's a very good thing.
The AQR Managed Futures Strategy (AQMIX) is a mutual fund that gives regular investors exposure to a futures trend-following strategy that trades upward and downward trends in stocks, bonds, currencies and commodities. Fees are relatively low for this fund -- just 1.23%. The minimum investment for this fund, however is very high.
A better option for investors with less capital is the Natixis ASG Managed Futures Strategy (ASFYX) , which has managed to outperform the rest of the category in four of the last five years. This fund's fees are slightly higher at 1.45%, but minimum investments are $100,000, which means that you don't need to have millions of dollars available in your retirement account to devote to alternatives in order to take advantage of this fund's performance.
Moving down the food chain, the WisdomTree Managed Futures ETF (WDTI) provides the lowest barrier to entry for a retail investor looking to get exposure to managed futures (at only $41 and change per unit), but its performance has also been the weakest over the last several years.
Another popular alternative fund is the market-neutral fund, which aims to make directional bets on individual stocks without exposing investors to the movements of the underlying market. This is a strategy that's been popular with hedge funds for decades but has only recently become readily available to individual investors.
The TFS Market Neutral Fund (TFSMX) is a mutual fund that tries to target statistical market mispricings by buying stocks that will go up and shorting stocks that will go down, for a net neutral portfolio. The fund has managed to outperform the rest of the category in four of the last five years, but that comes at a cost: The TFS Market Neutral fund has slightly higher-than-average fees.
On the ETF front, the IQ Hedge Long/Short Tracker ETF (QLS) , launched back in March, is one of the few ways to get exposure to a long/short strategy, which is a close cousin of market-neutral funds. This ETF tries to deliver performance similar to a long/short hedge fund, a vehicle that most retail investors don't have access to. This fund benefits from low fees and the liquidity features of an ETF, but its relatively short track record is a detractor.
Real Estate Realities
Real estate is another asset class that tends to have a relatively low correlation with the stock market. The problem is that the vast majority of real estate funds just own a basket of publicly available REITs, which, as previously mentioned, tend to behave like a highly correlated interest rate play rather than providing true exposure to the real estate market.
So while big mutual funds such as the T. Rowe Price Real Estate Fund (TRREX) or ETFs such as the Vanguard REIT ETF (VNQ) are great ways to get access to a diversified basket of REITs, they're not true alternatives. That said, in environments such as the one we're in now, where real estate prices are generally trending higher and investors are generally anticipating interest rate hikes, REITs can become undervalued. That makes this space an interesting corner of the market to have exposure to, even if there isn't a good way to get true alternative exposure to it.
Can't decide on a single type of alt fund to invest in? Then why not go with a multi-strategy fund?
Multi-strategy funds try to own exposure to several strategies within a single fund, ideally providing a one-stop shop for investors in search of uncorrelated returns. Like most generalists, these funds tend to be a jack-of-all-trades and master of none, but they're a good way to get quick exposure.
For instance, one popular multi alt fund is the IQ Hedge Multi-Strategy Plus Fund (IQHIX) , which tries to mirror six hedge fund indices for a relatively low expense ratio. Like the other funds we've looked at, this one consistently beats its Morningstar category, but by much thinner margins.
A more accessible alternative to this fund is the ETF version of it, the IQ Hedge Multi-Strategy Tracker ETF (QAI) . The ETF doesn't use leverage (unlike the mutual fund flavor of this strategy), but it does sport a much lower expense ratio of 0.97%.
The aptly named ProShares Morningstar Alternatives Solution ETF (ALTS) provides a similar multi-strategy model based on a basket of other ETFs.
Any way you slice it, there are more alternative investments available to investors than ever before. You might want to think of these unique vehicles like a sort of insurance policy. They'll typically lag the big stock indices during rip-roaring rally years, but alts shine when stock performance goes into the gutter and nothing seems to be working for your portfolio.
For that reason, it's a good idea to keep alternative exposures lower than your current core holdings.
Be sure to avoid the pitfalls of picking an alternative fund, and these unique investments could be the key to outperforming your neighbors when the next financial hiccup comes calling.