Assets held in alternative funds have seen a big surge in growth in recent years as investors search for investments that can offer high yields and higher returns, while maintaining some downside protection.

alternative fundsAnd now this rise in investor interest in alternative mutual funds, particularly those known as “liquid alts,” has attracted the interest of the Securities Exchange Commission. Other than the recent surge in assets for liquid alts, there are a few primary factors for the SEC’s interest in these alternative funds:

  • Liquid alts are a relatively new investment product for everyday investors, so the potential risks may not be clearly understood.
  • The managers of alternative mutual funds themselves may not be fully aware of the regulatory requirements they must follow under the Investment Act of 1940, which applies to all mutual funds, including liquid alts.
  • The SEC is concerned that liquid alts may not be as liquid as their name implies.

Are the SEC’s concerns justified? Before answering this question, let’s take a closer look at how alternative funds work.

The Nature and Risks of ‘Liquid Alts’

Liquid alternative funds offer investors a means of diversifying beyond a mix of stocks and bonds found in similar funds that are more mainstream. But liquid alts and other alternative funds invest in less understood assets, such as futures, currencies, bank loans and convertible bonds.

In some regard, alternative funds are the poor man’s hedge fund. However, since the liquid alts under the scope of the SEC are organized as mutual funds, they may not be able to withstand a rush of redemptions from shareholders should markets turn more volatile. Therefore the downside risk investors may be seeking could be greater than it may seem on the surface.

This is ironic because many investors are attracted to liquid alts because they are more accessible, and thus more liquid, than hedge funds. So if a shareholder of a liquid alt fund wanted the redeem shares for withdrawal, they should be able to do so more easily than with hedge funds. But the ability of hedge funds to hold off redemptions in volatile markets is what helps insulate them from a mutual fund version of a “run on the bank,” as financial markets saw in the Great Depression and in the more recent Great Recession.

How to Analyze Alternative Funds

Part of the problem with liquid alt funds, which justifies the scrutiny of the SEC, is that they’re not all labeled as such and most investors aren’t in the practice of reading a prospectus prior to buying mutual funds.

Alternative funds usually have phrases, such as “multi-asset” or “alternative income” or “unconstrained bond” in their names. These funds also tend to have much higher expense ratios, often near 2%, as compared to traditional mutual funds that typically have expenses closer to 1%.

Before buying an alternative mutual fund, it’s a good idea to fist check the amount of assets under management, or AUM, which can give at least some assurance that the fund can withstand challenging markets and stay more liquid than other alternative funds. For example, a liquid alt fund with $1 billion (with a ‘B’) in AUM is likely to be more liquid than one with $1 million (with an ‘m’) in AUM.

You also need to look at the objective and the holdings of the fund. For example, there are several subcategories of liquid alternative mutual funds, such as Alternative Event Driven, Alternative Managed Futures and Alternative Multistrategy, and each category invests in different types of alternative assets. If you don’t understand the objective and the underlying holdings of the alternative fund, you probably shouldn’t buy shares of it.

Bottom Line With Liquid Alts: Buyer Beware!

To answer the question as to whether the SEC is justified in its scrutiny of alternative funds, yes, there is absolutely good reasoning in their investigating the potential risks of these funds.

Investors are smart to pay attention to the overriding trend of new mutual funds and ETFs coming on the market, especially those arriving in the past few years. When there is little history to review, there is little understanding of the potential risks involved with a particular investment. Past performance is no guarantee of future results and just a few years of historical returns can be akin to a crap shoot on predicting future performance.

The liquid alternative investments really gained in popularity in the past two to three years. Within that time frame there has been no real test in terms of a bear market correction or short-term panic selling environment that would provide useful information about the validity, sustainability, and more importantly, the liquidity of liquid alts.

As with other security types, there are likely to be some that can be prudent investments and some that may be train wrecks waiting to happen.

I suspect there will be a time in the not-too-distant future where alternative funds will serve as yet another reminder that the traditional forms of diversification prove to be smarter for the vast majority of investors than the latest trends.

Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. He personally does not hold any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.

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