FINRA Issues Investor Alert on Alternative Funds

The Financial Industry Regulatory Authority (FINRA) recently released an investor alert entitled "Alternative Funds Are Not Your Typical Mutual Funds". FINRA defines Alternative (Alt) Funds as mutual funds that "seek to accomplish the fund's objectives through non-traditional investments and trading strategies."

These funds have garnered significant assets in recent years -- over $175 billion as of May 2013 -- as investors stretch beyond traditional stock and bond allocations for additional yield. According to Reuters, FINRA is particular concerned about mutual funds that "that turn around and invest in shares of hedge funds." Hedge funds, unlike mutual funds, are not subject to the provisions of the Investment Company Act of 1940 and as a result have essentially free-range over the types of strategies and investments they may consider. These investments frequently include obscure, illiquid and/or risky assets that would typically be unsuitable for a retail investor.

Alternative fund strategies are sometimes marked by high turnover, which can be a drag on performance due to transaction costs. In addition, managers of alternative funds may have higher expense ratios since running their funds may require more skill (read: compensation). There is also no guarantee strategies (or managers) that have performed well in the past will continue to do so. In fact there is little evidence for persistence in active strategies at all. Even if a persistently successful strategy was found -- as pointed out by a recent Barron's story --the assets underlying these strategies would typically become more expensive as other managers mimic the strategy, diminishing realizable returns over time.

There was an interesting discussion about alternative funds at the recent 2013 Morningstar Investment Conference. When asked what the biggest challenge to investing in alternative funds is, all three panel members agreed that investor education and understanding are the main issues:

Alford: Due diligence is crucial, but many advisors don't have experience with alternatives. With traditional alternatives such as hedge funds, managers do not offer much transparency into portfolio positions or investment process, making these investments difficult to evaluate....The stakes are high for picking the wrong managers.
Raby: Educating clients on the nuances of alternative funds.
Bregman: The biggest challenge is fully understanding the risk-and-return opportunities of particular strategies in particular market environments.

It's important to realize that there are several levels of complexity that both advisors and investors need to understand. They must understand the alternative fund itself, its purported role in the client's overall portfolio, as well as the investments underlying that fund. Investors are also encouraged to check the background of the fund manager using FINRA's BrokerCheck system.