In 2008, when the S&P 500 fell 37 percent, the funds in Morningstar's open-ended long-short category fell 15.4 percent. When the S&P surged 26 percent the following year, the long-short category gained only 10.4 percent. It's up an annualized 5.6 percent for the past three years, compared with 15.6 percent for the S&P.
Many alternative funds offer "bond-like returns with correlations that are very different from equities as well as bonds," says Morningstar alternatives analyst Josh Charney. "Most have a volatility range that's somewhere between equities and bonds."
When sizing up alternative strategies, Charney says, investors should be looking not at absolute return—the number that shows up on your quarterly statement—but returns that are adjusted for risk. Professionals do that using Sharpe ratios and other arcane metrics, but there's a simpler way, says Alan Reid, CEO and co-founder of Forward Management, investment adviser to Forward Funds.
"The easiest way for [investors] to think of it is to count the number of bad periods," says Reid. "If the alternatives manager is adding value, you should see considerably fewer negative periods than positive periods."
To be sure, there are things you should know about alternative funds before you leap into them. For one, their fees are much higher than the 75 basis points (bps) that the average mutual fund charged last year. Excluding nontraditional bonds, they ranged from 142 bps for currency strategies to 287 bps for managed futures.
"The fees don't seem to be commensurate with the return goals," says Morningstar's Charney. "Investors need to understand that. We've started to harp on that point, and we probably should a little bit more."
Investor psychology can pose problems, too. Morningstar research has shown that the average investor does worse in alternative funds than in traditional funds, because of poor market timing, one the biggest faults of retail investors. There is often a significant gap between total returns and what Morningstar calls "investor returns"—what an investor actually experiences depending on when she enters or exits a fund. But the gap is considerably wider for alternative funds than for traditional funds, Morningstar says, partly because people tend to view them as short-term, non-core holdings that suddenly feel dispensable when markets start slipping.
How much should investors allocate to alternative strategies? Morningstar's Charney says it depends on your appetite for risk, and recommends gradually allocating to the category. One thing to keep in mind is that today's alternative assets are tomorrow's core holding. A decade ago, real estate and commodities were considered alternative assets. Now, not so much. In fact, says Reid, whose firm offers several alternative funds, the riskiest portfolio is not one with alternatives but one with no alternatives.
"I would be more comfortable in a group of alternative funds than being 100 percent in the S&P index," says Reid. "Someone looking for highest return—in emerging markets, small caps, high-yield—typically wouldn't have alternatives. Alternatives are for the middle market, if you will—not those investors looking to hit the sky, but those seeking consistent rates of return."