Alternative Mutual Fund

An alternative mutual fund is an open-end investment company, registered with the SEC under the Investment Company Act of 1940, whose strategy departs from the traditional mix of long-only stocks, bonds and cash. In the SEC's definition, alternative mutual funds ("sometimes called alt funds or liquid alts") are "publicly offered, SEC-registered mutual funds that hold non-traditional investments or use complex investment and trading strategies." The SEC's examples of the holdings include global real estate, start-up companies and commodities such as gold or oil, and of the strategies short selling, derivatives, and "absolute return" or "market neutral" approaches that seek positive returns even when stock markets fall. The name describes what the fund does, not a separate legal category: legally it is a mutual fund like any other.

What the mutual fund wrapper adds. The SEC notes that alt funds often pursue strategies similar to hedge funds and are sometimes "marketed or sold as 'hedge fund-like' options for retail investors," but that they differ in important ways. Because they are mutual funds, the Investment Company Act's safeguards apply: "limits on illiquid investments, restrictions on borrowings and debt, and the requirement to allow investors to sell their shares at any time." The illiquid-investment limit is concrete. Under the SEC's liquidity rule, a fund may not acquire an illiquid investment if afterward more than 15 percent of its net assets would be in illiquid investments, meaning investments it reasonably expects cannot be sold within seven calendar days without significantly changing their market value. A hedge fund is not required to follow those rules; in exchange, it may be sold only to accredited investors or qualified purchasers.

What the wrapper does not remove. Daily liquidity for the investor does not make the strategy itself liquid or simple. The SEC lists the extra risks an alt fund may carry, depending on its strategy, as derivatives and leverage, futures contracts, short selling and swaps. A fund running a strategy that depends on holding positions through a downturn must still pay out shareholders who sell during it, and the more of its portfolio that is slow to sell, the harder that becomes. The tension between a promise of daily redemption and a strategy built for patience is a structural risk particular to the category.

Costs and track records. The SEC observes that many alt funds charge an annual fee of 2 percent or less of assets, compared with a hedge fund structure such as the so-called "2/20," a 2 percent fee plus 20 percent of profits, but also that alt funds may cost more than traditional mutual funds, because the strategies take more active management and can generate expenses of their own. Many were launched after 2008, the SEC adds, "so it is not known how they would perform in a down market," and they may behave differently from broad indexes such as the S&P 500.

An alternative mutual fund collects investors' money, prices its shares at net asset value at the end of each business day, and pays out shareholders who sell, like any mutual fund. What differs is inside: the manager may short stocks it expects to fall, trade futures across markets, hedge with derivatives, or combine several such strategies, within the Investment Company Act's limits.

For example: two investors each put $50,000 into strategies that earn 8 percent before fees in a year, a $4,000 gross gain. One owns an alternative mutual fund with a 1.8 percent annual expense ratio, which costs about $900 ($50,000 times 1.8 percent). The other owns a hedge fund charging 2 and 20: a $1,000 management fee (2 percent of $50,000) plus a performance fee of $800 (20 percent of the $4,000 gain), or $1,800. A fund that takes its performance fee from just the gain left after the management fee would charge $600 instead, for $1,600 in total. Ignoring the effect of fees being charged during the year, the alt fund investor keeps about $3,100 of the gain and the hedge fund investor about $2,200 (or $2,400 with the smaller performance fee). Against a broad index fund charging 0.05 percent, about $25 a year on the same $50,000, the alt fund's cost is still large.

Pros

• Open to any investor, with daily redemption and SEC registration.
• Investment Company Act limits on illiquid holdings and borrowing apply, which a hedge fund does not face.
• Some strategies aim to behave differently from stocks and bonds, which can add diversification if they work as intended.
• Fees are generally lower than a hedge fund's.

Cons

• Expenses are often well above traditional mutual funds and index funds.
• Complex strategies using derivatives, leverage, short selling and swaps carry risks that are hard to see from outside.
• Many funds have short histories and have not been tested in a severe downturn.
• A strategy built for patience must still meet daily redemptions, which can force sales at bad times.
• Being marketed as "hedge fund-like," which the SEC notes happens, says nothing about whether a particular fund's strategy will work.