Multialt fund: A hedge with its own risks

Multialternative strategy mutual funds have become one of the fastest-growing fund subcategories, and that should be a red flag for financial advisers to sharpen their due diligence on these products.

Most interesting about the surging growth — with assets almost doubling, to $33.8 billion, and the number of funds up almost 50%, to 120, over the past 18 months — is that it isn’t about chasing performance.

In fact, the category’s average return this year through mid-July was just under 2%, according to Morningstar Inc. Its average last year was a gain of 4.2%.

Meanwhile, the S&P 500 was up 8.7% by mid-July. The index gained 32.4% last year.

What’s driving the growth in the multialternative category is a heightened sense of risk aversion as the equity markets continue to push new highs.

From a financial planning perspective, one could argue that things are unfolding according to plan. When valuations get rich, pull some chips off the table and feel comfortable with a little hedge.

So far, so good.

But the challenge for investors and advisers gets back to the same issues they confront every time a particular fund category starts to get hot. Sometimes sales and marketing lead the way, and the actual strategies can become a secondary focus.

Most vulnerable are those in-vestors, and even some advisers, who might be new to alternatives but subscribe to the idea of hedging some risk at current market levels.

PLUG-AND-PLAY

Right off the top, the notion of a multialternative mutual fund sounds like an easy plug-and-play solution.

But a look under the hood of the products in the category reveals that these mutual funds, which invest in several different underlying alternative strategies, are not all created equal. Fact is, even Morningstar acknowledges that the category has become somewhat of a catch basin for strategies that don’t fit neatly elsewhere.

Among the 120 distinct funds in the category, only about a third allocate to outside mutual funds and money managers for what is typically structured as an underlying portfolio of a half-dozen or more slices of alternative investment exposure.

Looking only at those funds that best fit the category as offering diversified alternative-strategy exposure in the form of a fund of funds, one of the biggest distinctions among funds relates to whether the underlying portfolios are allocated to other registered alternative mutual funds or to separately managed accounts that are often managed by hedge funds or other private money managers.

SEPARATE ACCOUNTS

From a marketing perspective, there might be an advantage to touting a multialternative mutual fund that is allocated to hedge fund separate accounts.

But that edge doesn’t always show up in the performance numbers.

Of the 45 funds in the subgroup, those funds using underlying registered mutual funds have averaged better performance over the past few years.

On a three-year annualized basis, six of the top 10 multialternative funds allocating to outside managers are investing in registered mutual funds as opposed to hedge fund separate accounts. On a trailing 12-month basis, the funds of mutual funds hold seven of the top 10 spots, and year to date through July 14, funds of mutual funds made up half the top 10 funds.

Bradley Alford, chief investment officer at Alpha Capital Management, believes the performance gap relates to the type of hedge fund managers the multialternative mutual funds are able to attract to run the underlying separate accounts.

Citing the typical hedge fund fee structure of 2% on assets and 20% on performance, Mr. Alford asks, “What good 2-and-20 manager is going to take a pay cut to manage money for a mutual fund?”

‘ADVERSE SELECTION’

“I think they’re getting adverse selection, because they’re getting the B-level managers who aren’t good enough to charge 2% and 20%,” he said. “And if you do have a manager charging 2-and-20 in his hedge fund, do you think he’s going to put his best ideas in the separate account he’s managing for 1%?”

The category average expense ratio is 1.83%.

Mr. Alford admittedly has a dog in the fight as the manager of two multialternative funds of mutual funds, Alpha Defensive Alternatives (ACDEX) and Alpha Opportunistic Alternatives (ACOPX), each of which hovers near the top performers.

Andy Dudley, senior portfolio manager at Context Asset Management, acknowledges some of the performance disparity but insists investors should be paying attention to the quality of the underlying portfolio managers in a strategy designed to be a diversifier.

“To the extent that some funds have exposed themselves to traditional market risk, they have won in these markets,” he said. “Strategies that have leaned with the market will populate the upper end of the performance spectrum.”

Mr. Dudley manages the Context Alternative Strategies Investor Fund (CALTX), which was launched in March as a strategy that allocates to separate accounts.

“In some cases these multistrat funds are trying to mix a full range of asset class exposures,” he said. “We’re trying to get at the skill and the value of the individual subadviser to actually generate alpha.”