These Alternative Funds Have Delivered

Alternative mutual funds are touted as a way to bring nontraditional investing strategies such as those used by hedge funds to individual investors while adding diversification to and/or reducing volatility in their portfolios. In a time of lackluster stock returns and low yields on fixed-income vehicles, these relative newcomers to the mutual funds menu have been garnering attention from those seeking to break out of the traditional stock/bond portfolio mix. In fact, alternative funds saw the second most net inflows of any fund asset class last year, adding $12.2 billion (taxable bond was far and away the leader, adding $130.2 billion, while U.S. stock funds saw the greatest outflows at $84.7 billion). In the first four months of 2012 alternative funds added another $3.5 billion in net inflows, with total fund assets estimated at $73 billion as of April 30.

Alternative funds come in many different varieties, and Morningstar has developed category designations that allow for apples-to-apples comparisons of various approaches. (Full descriptions of these alternative fund types may be found beginning on Page 25 of The Morningstar Category Classifications document.) Some alternative funds provide access to nonstock, nonbond investment vehicles--such as currencies or precious metals--while others utilize trading strategies designed to provide downside protection against a falling equity market and/or to reduce volatility. Among these fund types are long-short equity funds, which hold both long and short positions in stocks; market-neutral funds, which hedge out most equity market exposure by taking offsetting long and short positions, thus zeroing in on nontraditional risk factors, such as illiquidity or event risk; and bear-market funds, which primarily use short positions in anticipation of stocks declining.

There's no one perfect way to gauge the relative success or failure of alternative funds because they come in so many different forms and seek to accomplish different things. However, we thought it would be interesting to see how some equity-oriented alternative funds have performed over a long time horizon relative to the market. We settled on the trailing-five-year period to include both the market dive of 2008-09 as well as the rebound that followed and to provide a good all-purpose view of how alternative funds perform over time. (Only a handful of alternative funds have been around long enough to earn 10-year records.) As our benchmark we used the trailing-five-year performance of the S&P 500, which, as of June 18, had an annual return of negative 0.41%. Thus, it's a time period when one might have expected alternative investments to fare reasonably well.

We used our  Premium Fund Screener tool to screen on alternative funds that use bear-market, long-short equity, or market-neutral strategies because those are the ones with a connection to stock market performance. We eliminated extra share classes using the Distinct Portfolio screen, took out funds available only to institutional investors, and stuck with funds that are open to new investors and with minimum investments of $10,000 or less. We included both load and no-load funds to broaden the pool.

The result: Out of 88 funds meeting our criteria, only nine--about 10%--outperformed the S&P 500 during the past five years, and all those were long-short equity or market-neutral. (No bear-market funds made our list, in part because of issues with the strategy that Morningstar's Paul Justice lays out in this article.) That's not to say that the funds that returned less didn't serve a purpose as hedgers or risk reducers, but on the basis of total return, few of the alternative funds among the groups we included in our screen outperformed. To view the funds that managed to beat the market during the past five years, click  here. Below are two of these funds.

 Arbitrage (ARBFX)
Strategy: Market-Neutral | 5-year annual return vs. S&P 500: +4.01 points
This fund targets mergers and acquisitions, buying the stocks of companies being acquired while often shorting the stocks of the acquiring companies. This provides a profitable spread if the deal closes. It doesn't attempt to anticipate mergers, but rather to profit from mergers that have already been announced. The fund tries to avoid companies involved in mergers facing regulatory or financial hurdles or hostile takeovers, and it invests globally and across all market caps with a focus on smaller companies worth between $500 million and $1 billion. The fund has lost money in only two of the past 10 years (and less than 1% each time) while ranking in the top 1% of market-neutral funds during that period. The fund reopened to new investors in March after closing in mid-2010. This is a no-load fund with annual expenses of 1.52%, below average for its category. (Data shown is for R class shares; I class shares are also available with no load.)

 Wasatch Long/Short   
Strategy: Long-Short Equity | 5-year annual return vs. S&P 500: +2.82 points
The no-load fund holds long positions in stocks its managers think are undervalued and short positions in those they think are overvalued. The goal is to deliver equitylike returns with less volatility than the market. The net long exposure can vary widely, from 30% to 90% of assets. The fund's 20.9% loss in 2008 beat the S&P 500 by more than 16 points while its 30.1% return during the market rebound in 2009 beat the index by 3.6 points. The fund's 2.41% annualized return during the past five years puts it in the top 8.00% of all long-short equity funds. This fund charges 1.30% in fees, below average for alternative no-load funds. 

Performance data as of June 18.