Noting surge in inflows, Bowden calls the funds 'bright, shiny objects' with sharp edges.
The head of the Securities and Exchange Commission's examination program warned investment advisers on Thursday to be careful when putting their clients in alternative mutual funds.
The SEC has noticed increased use of nontraditional investments and complex trading strategies in mutual funds, said Andrew Bowden, director of the Office of Compliance Inspections and Examinations.
The assets in alternative mutual funds grew to $258 billion in October, from $158 billion a year earlier.
“Alternative funds are the bright, shiny object,” Mr. Bowden told an audience of 250 at the Investment Adviser Association Compliance Conference in Arlington, Va. “But they're a sharp object.”
(See also: SEC off to aggressive start in 2014, but can it follow through?)
Although using alternatives can increase returns, they also leave investors vulnerable in market downturns if the products have limited secondary markets.
“The use of market valuation for illiquid securities in an open-ended mutual fund, which requires daily valuation and offers daily liquidity is fraught with risk,” Mr. Bowden said. “If any of you are considering launching a mutual fund that uses alternative investments or strategies, I implore you to evaluate the reasonableness and the effectiveness of your controls.”
(Wealthy investors dumping cash and equities, buying alternatives)
Another area that the SEC is monitoring is the transfer of clients from brokerage accounts to fee-based wrap accounts at investment advisory firms that are dually registered as brokers. The SEC is concerned that many clients are parked in accounts that charge a fee on assets even though there is little trading in the account and low commission costs.
“We see instances where the value proposition to clients is not clear. The movement to fee-based wrap accounts is a widespread practice,” Mr. Bowden said.
“A lot of people have jumped into the pile,” he said. “We fear that the rationalization that everyone is doing it may be adversely affecting people's thinking about how some of these arrangements are in the best interest of their clients.”
As an example of its concern, the SEC published an investor bulletin last week about the impact of fees on investor returns, Mr. Bowden said.
In his more than two years at the SEC, he said that he has noticed that people run into the trouble with the commission for behavior in one of three areas: lying, cheating or stealing; acting recklessly; or having their judgment clouded by conflicts of interest.
The vast majority of investment advisers act ethically and legally but, comparing the situation to a neighborhood park, it just takes one person “peeing in the pool” to create problems for the whole sector, Mr. Bowden said.
An earlier version of this story misstated the growth of assets in alternative mutual funds from October 2012 to October 2013. Assets grew to $258 billion in October, from $158 billion a year earlier.
