One of the hottest areas for U.S. money managers is quickly cooling off.
Flows into hedge fund-like mutual funds, a category that attracted almost a third of the money going into actively managed funds in the past six years, have slowed this year to the weakest pace since 2008. The strategies, which include non-traditional bond funds and alternative stock funds, attracted just $1.2 billion from investors in the first five months of 2015, according to Chicago-based Morningstar Inc., down from $39 billion last year and a record $96 billion in 2013.
The funds, whose rapid growth has prompted scrutiny from regulators, trailed last year as stocks and bonds rallied. The rapid drop in investor interest is a setback for firms such as Goldman Sachs Group Inc. and Pacific Investment Management Co., which had counted on the fashionable strategies to win back clients into higher-fee products amid a general flight to cheaper, passive vehicles.
“Stocks and bonds did so well last year that a lot of people asked themselves: 'Why do I need to own alternatives?'” said Lawrence Glazer, managing partner at Mayflower Advisors in Boston, where he helps oversee $2 billion.
The prospect for such funds could improve if the stock market slumps or if interest rates go up rapidly.
The initial appeal of the new funds was simple, especially for investors who lost money in traditional funds during the 2008 financial crisis. If wealthy individuals and institutions could put their money into vehicles with the flexibility to make money in all kinds of markets, why not ordinary investors?
That helped long-short equity funds and absolute-return funds win deposits after 2008. Non-traditional bond funds got a boost in 2013 when interest rates shot up after the Federal Reserve hinted in May of that year that the central bank might cut back its bond-buying program. In total, these strategies attracted about $253 billion in the six years through 2014, about 29% of all money that flowed into active U.S. mutual funds.
“The concept was sexy to a lot of people who had read about hedge fund managers making billions of dollars,” said Burton Greenwald, a mutual fund consultant based in Philadelphia.
With the client cash came attention from regulators, who questioned whether individuals understood the risks of investing in such vehicles, known as liquid alternative funds. Examiners at the Securities and Exchange Commission began looking into alternative funds last year for how they comply with leverage and liquidity rules, and whether their boards are appropriately overseeing their activities.
SEC Commissioner Kara Stein said last week that new regulations may be needed to rein in funds that are evading the limits on their holdings of riskier investments such as derivatives and other hard-to-sell assets.
The funds use such instruments in part to juice returns in adverse markets. They didn't do well last year, when the S&P 500 Index returned 14%, including reinvested dividends. Intermediate bond funds, the most popular fixed-income investments, gained 5.2%, compared with 1.2% for their non-traditional competitors, Morningstar data show.
“Alternative strategies are bound to lag when markets are going up as much as they have,” said Josh Charney, a Morningstar analyst.
Investors responded by pulling money out. Three of the four largest unconstrained bond funds, the $22 billion Goldman Sachs Strategic Income Fund, the $20 billion JPMorgan Strategic Income Opportunities Fund, and the $9 billion Pimco Unconstrained Bond Fund, suffered redemptions in 2015, according to data compiled by Bloomberg.
On the alternatives side, the $5.5 billion Mainstay Marketfield Fund has been the poster child for shifting sentiment. Investors poured money into the long-short fund in 2013 after manager Michael Aronstein consistently beat peers from 2008 to 2012. They headed for the exits after he lost 12% in 2014, hurt by wrong-way bets on commodity stocks. In the 12 months ended May 31, the fund experienced more than $13 billion in withdrawals, Morningstar data show.
Mr. Glazer and others say individuals, known for chasing performance and timing decisions poorly, may be getting it wrong again. With interest rates finally set to increase and stocks moving sideways, investments that aren't correlated with traditional assets might be more attractive.
“People should be looking for investments that have the possibility of doing well in market environments where the expected returns are more anemic,” said David Kabiller co-founder of AQR Capital Management, which manages $140 billion and runs the industry's largest alternative mutual fund.
BUCKING THE TREND
Some funds have bucked the trend. Rick Rieder's $30.7 billion BlackRock Strategic Income Opportunities Portfolio beat 80% of non-traditional bond rivals over the past year and pulled in $14 billion in deposits.
The $7.5 billion John Hancock Global Absolute Return Strategies Fund attracted $1.9 billion over the same period after producing gains every year since 2012. The fund is designed to provide positive returns with less volatility than the stock market, said Andrew Arnott, president of John Hancock Investments in Boston, where he oversees $125 billion.
“If all goes well, this fund should give people a boring ride,” he said.
So far, 2015 has been favorable for alternative strategies amid global market volatility and slower stock-market gains. Through May, hedge fund returns, as measured by the Bloomberg Global Aggregate Hedge Fund Index, topped the gains in the S&P 500. On the bond side, non-traditional funds are doing better than their conventional counterparts, Morningstar data show.
This sort of market might help get investors back in, said Kevin Quirk, one of the founding partners of Casey, Quirk & Associates, a consulting firm that specializes in asset management.
“Alternatives will have greater appeal in a more difficult market,” Mr. Quirk said.