The four flavors of multialternatives have widely differing tastes

With the equity markets appearing to layer on more risk with each passing day, it’s not surprising that the category of mutual funds labeled multialternative would be gaining appeal as a reliable means of reducing risk.
Trouble is, the funds making up the category are less homogenous than one might think, a situation that could lead to confusion among investors and financial advisers who are adding exposure to the growing universe of alternative strategies.
Unlike some of the more generic fund categories, such as large-cap growth, the initial screens related to issues such as fees and performance can fall well short of standard expectations when it comes to researching multialternative mutual funds.
Even Morningstar Inc., which tracks 122 multialternative funds, admits the category has become a kind of catch basin for some alternative strategies that don’t fit anywhere else.
Through the end of July, assets in the category have grown to more than $34 billion, up from $29 billion and 108 funds at the start of the year. At the beginning of 2010, the category counted 50 funds and $7.6 billion in assets.
The broader multialternative category has expanded to the point that there are now four unofficial subcategories: Funds of alternative mutual funds, funds that allocate to underlying separate accounts, single-manager funds that often embrace a global-macro approach, and funds that use futures and exchange-traded funds to replicate various hedge fund benchmarks.
Morningstar fund analyst Jason Kephart said it takes about 20 funds to justify a separate category, and there are currently only a handful of index trackers, including the $3 billion Natixis ASG Global Alternatives Fund (GAFYX), and the $240 million Alpha Hedge Strategy Fund (IQHIX).
Like a lot of funds in the alternatives space, the index trackers have been showing increased stock market beta, which helps them shine in a bull market, but gets low points as a potential market hedge.
“These funds look at the hedge fund indexes and try to replicate them a month later” because the hedge fund data is always delayed, Mr. Kephart said. “They have a 0.9 correlation to stocks, which is higher than any other type of multialternative fund.”
Single-manager funds adopting a global-macro approach might be the purest-play alternative strategy in the category, but that doesn’t make them immune to favoring long-equity-market exposure in an effort to keep up with a hot stock market.
Two examples of the single-manager funds are the $5.8 billion John Hancock Absolute Return Fund (JHAIX), the largest fund in the space, and the $325 million UBS Dynamic Alpha Fund (BNAAX).
In the two remaining subcategories, the distinctions are not always easy to identify, and the debate can get enthusiastic.
The brouhaha centers on whether it is wise to use registered mutual funds as underlying investments, or whether to allocate assets to separate account managers, who are often — but not always — hedge fund managers.
“By allocating to separate accounts, it does give the manager some extra work to do. You have to pay attention to each portfolio, because the overall fund still has to be compliant as a mutual fund,” said Rick Lake, co-chairman of Lake Partners Inc. and manager of the $520 million Aston/Lake Partners Lasso Alternatives Fund (ALSOX), which invests in other registered funds.
Mr. Lake believes that in order to comply with mutual fund rules, a portfolio manager could be forced to alter some of the underlying separate account portfolios. That could dampen the valuable alpha performance from the underlying managers. Another issue is that the fund manager needs approval from the fund board to add or remove an underlying manager.
Funds allocating to other registered mutual funds, by contrast, can make changes on a daily basis at the portfolio manager’s discretion.
It has also been argued that any hedge fund worth its high fees is not going to be interested in dabbling in the less lucrative retail marketplace. Therefore, the logic goes, funds using separate accounts are getting subpar managers.
To that, Brad Balter, managing partner at Balter Capital Management, a $1.5 billion asset management shop, pushes back with the reality that as businesses, hedge funds are going where the money is. And that means retail.
“The alternatives environment has changed and there are significant assets to be gathered in the retail space,” said Mr. Balter, co-manager of the $122 million Balter Long/Short Equity Fund (BEQIX), which allocates to separate accounts.
“Big or small, as a hedge fund manager, you would be remiss to not get involved in what is the fastest-growing part of the asset management industry,” he added. “They realize they can’t look at their hedge fund as a fee machine and that they have to look at it as a business. And the retail market is a business line that they want.”
Mr. Balter said the required step of going through a fund board to make portfolio changes makes his job more challenging, but he also enjoys a fully transparent view of the positions in the underlying separate accounts. That will never be possible when the underlying holdings are other mutual funds that report holdings on a one-month delay.
“I feel so much better that I can actually see what’s going on in the portfolio,” he added. “Separate accounts are the solution, not the problem.”
But Brad Alford, chief investment officer at Alpha Capital Management, believes the transparency argument is overrated.
“That’s the same thing hedge funds of funds have been doing forever, and has that really helped anyone?” asked Mr. Alford, who manages the $75 million Alpha Opportunistic Alternatives Fund (ACOPX) and the $40 million Alpha Defensive Alternatives Fund (ACDEX), both of which invest in registered alternative funds.
“I have great comfort knowing our underlying managers each have to follow the ’40 Act rules,” he added. “I predict that in the next correction or prolonged downturn, some of those underlying separate accounts will implode.”
So even as assets continue to pour into liquid alternatives, the debate continues and the demarcation lines remain blurred. Advisers and their clients need to take a slow and steady approach to due diligence because it will pay off when the bull market ends.