Alternative funds are mutual funds, or exchange-traded funds (ETFs), that invest in nontraditional securities, such as real estate, commodities, and leveraged loans. These funds are not generally appropriate for most investors, but they may be used as diversification tools if used properly.
Alternative mutual funds can be a smart way to gain access to nontraditional investment securities. However, before investing in alternative funds, investors should do extensive research to determine if these investment types are appropriate for them.
Alternative Funds Definition
The term “alternative funds” generally refers to mutual funds, hedge funds, or exchange-traded funds (ETFs) that invest in nonconventional investment securities, which may be broadly categorized as securities other than stocks, bonds, and cash. Alternative funds may invest in real estate, loans, commodities, and unlisted securities, such as art or jewelry.
Alternative Funds Investment Strategies
Alternative funds are most commonly used for portfolio diversification strategies because performance for alternative investments typically has a low correlation to that of the broad market indices, such as the S&P 500. Some alternative funds may have focused investment strategies, meaning they invest in one area, such as commodities. Other alternative funds may invest in a range of alternative investments.
Alternative mutual fund strategies tend to be more complex than conventional mutual fund strategies.
For example, alternative funds may invest in securities that are easily understood, such as derivatives, currencies, or distressed bonds. Alternative funds may also seek to achieve returns above market averages, or they may seek to achieve “market neutral” or “absolute returns” by using a combination of long and short strategies.
Before You Invest in Alternative Funds
Here are some things to consider before investing in alternative funds.
Since alternative funds invest in nontraditional securities, investors should be aware that price fluctuations can be greater than traditional securities, such as stocks and bonds.
Because of their nature, alternative funds tend to have higher expenses than most mutual funds and ETFs. For example, management costs can be high (above 1.50% expense ratio) for alternative funds because of the extensive research and high levels of trading (turnover) compared to the average actively managed mutual fund.
Because alternative funds do not typically have a clear legal structure, the contents of their portfolios may not always be clear to the investor. Do your best to know the fund’s objective and holdings. You should also understand what the holdings are and how they function in capital markets.
Since most alternative funds are actively managed, it’s important to know who is managing the fund. Be sure that the manager has years of experience and a track record of performance associated with the fund you are considering.
Past performance is no guarantee of future results, but it can give you an idea of what to expect from the fund. Look for long-term returns of at least five years, and avoid funds with shorter histories. Also, be cautious about investing in alternative funds with broad swings in performance (extreme highs and lows).
Many alternative funds have minimum initial investments, such as $10,000 or higher, or they may require the investor to have a net worth of at least $1 million before investing.
Bottom Line on Investing in Alternative Funds
Alternative funds are not for every investor. They typically have higher market risk, higher expenses, and higher minimum initial investments than the average mutual fund or ETF. Investors wanting to diversify can achieve similar results by building a portfolio with funds in different categories, capitalization, and assets. They may also diversify into focused areas, such as industrial sectors.
Investors may also choose mutual funds or ETFs that incorporate alternative securities or strategies into their portfolios. Although alternative funds are not necessary for diversification and are not needed to achieve returns that exceed broad market averages, they may be used properly if the investor uses caution and does their research before investing.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.