To Be Truly Diversified, Do Investors Need Alternative Funds?

A survey shows that 71 percent of advisers advocated using alternatives.

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Steep losses from the market meltdown have many investment advisers reconsidering the way they run clients' portfolios. To add more diversification—and therefore, hopefully mitigate future losses—more advisers are looking to alternative investments, such as mutual funds that hedge their positions, invest in commodities through futures contracts, or make currency bets. These funds may have both long positions, which are bets in favor of the underlying assets, and short positions, bets against the underlying assets. According to a new survey from Rydex/SGI, an investment firm, 71 percent of advisers advocate using alternative investments for their clients, while 19 percent of those surveyed said at least half of their clients were using alternative investments. Just over three-fourths of advisers surveyed say the primary reason they use alternative investments is to further diversify their clients' portfolios, up from 60 percent in 2007.

"Most advisers believe the investment landscape has shifted," says Sanjay Yodh, managing director for alternative strategies at Rydex/SGI, which interviewed former, current, and prospective clients from 427 registered investment adviser firms for the survey. The study also found that 61 percent of advisers expect to increase their use of alternative investments within the next three years.

[See top-rated funds by category ranked by U.S. News Score.]

Alternative investing strategies have long been used by institutional investors, but now retail investors have the opportunity to buy into them through mutual funds and exchange-traded funds. Many of these funds have a low correlation to more traditional investments like stocks and bonds, says Morningstar analyst Nadia Papagiannis, and can serve as good diversifiers. One of the most popular alternative strategies is using long/short mutual funds. The goal is to lose less or even make money when the stock market is going down. "Generally speaking, long/short or hedged strategies have the interpretation that they're more risky," Yodh says. "But I would suggest taking a long-only bet can be very, very risky because you can only make money when the market is moving up."

[See The Long and Short of Managing Volatility.]

Papagiannis cautions that alternative investments aren't for everyone. The performance of funds in the alternative category varies much more widely than within other asset classes, because the funds' strategies can differ greatly. For instance, funds in the long/short category can invest in stocks and bonds. Some invest much more heavily in stocks versus bonds. Others throw commodities and currencies into the mix. The bottom line, says Papagiannis: Investors should be cautious and should probably consult a financial adviser before jumping into alternative investments.

[See How to Inflation-Proof Your Portfolio.]

Some advisers warn that many of the strategies alternative mutual funds use are unproven. Adam Bold, founder of the Mutual Fund Store, an investment firm with more than $5 billion in assets, says his firm doesn't invest in long/short funds because he doesn't believe that many have a consistent track record of success.

As of July, there were 105 distinct long-short funds in Morningstar's database, up from 61 at the end of 2006. In a downturn, these funds are designed to lose less than traditional investments like common stocks, but when the markets rally, investors shouldn't expect these funds to keep up with traditional stock funds. In 2008, the average long/short fund lost 16 percent, while the average large-blend stock fund, which invests in a mix of value and growth stocks, lost 28 percent, according to Morningstar. The tables turned in 2009 when the average large-blend fund returned 28 percent versus the average long/short fund, which only gained 10 percent over the same time period. "When you want to go long and short, it's tough," Bold says. "There's not that many people that are very good at it."

[See The Case for Investing in Commodities.]