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By Jason Stipp and Josh Charney, CFA | 12-08-2014 04:00 PM

What Good Alternatives Funds Should Do for You

It's not just a matter of lowering your market risk, says senior alternatives analyst Josh Charney.

Jason Stipp: I'm Jason Stipp for Morningstar. This week we're rolling out Morningstar's Guide to Better Investment Picking, and today we're checking in with senior alternatives analyst Josh Charney about better alternatives investment selection.

Josh, thanks for joining me.

Josh Charney: Thank you, Jason.

Stipp: Alternatives is a pretty broad category. Lots of different types of funds might be in alternatives. How does Morningstar look at alternatives? How do we break it down?

Charney: We've always defined alternatives across three different buckets. The first is an alternative strategy. The second is an alternative asset class. And the third is an illiquid asset class.

For an alternate strategy, generally a fund would have to have some sort of hedging characteristic to it. For instance, a long/short equity fund can hedge 20%-50%.

For an alternative asset class, we're looking at asset classes that are uncorrelated to the market. … Currencies is a good example.

Then finally, an illiquid asset class that isn't really applicable to the '40 Act mutual fund space, but something like private equity or venture capital, we define as alternative as well.

That breaks down into seven different categories in the open-end fund universe that Morningstar defines as alternative, and those are bear market, multialternative, managed futures, market neutral, multicurrency, long/short equity, and non-traditional bond, which is a hybrid category that has some alternatives and some traditional funds as well.

Stipp: We've seen assets flowing into a lot of these different kinds of alternative mutual funds. In fact, there is now over $300 billion of assets in alternatives. What do you think has been the reason that they've seen the growth that they've seen?

Charney: The reason has evolved and changed over time. Part of the asset spike was following 2008, when investors were generally worried about getting into the market. Back then, long/short equity strategies were really popular. These funds had a much lower beta and had hedging characteristics to them.

Another strategy that has gained popularity as investors are looking for new sources of return are some option strategies. Bonds haven't really been yielding a whole lot, although Treasuries have been declining. People are worried about rising interest rates, and so option strategies are a good place to look.

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