Alternative Funds That Add Diversification

At a time when correlations have increased among many asset classes, finding investments that provide true diversification can be a challenge. 

A takeaway from the market collapse of late 2008 was that even a diversified portfolio of equities can get hammered in an environment when investors are fleeing riskier asset classes. While the S&P 500 index of large and mid-cap companies lost 37% that year, small-cap stocks lost about the same amount, and foreign and emerging-markets stocks lost even more (43% and 53% respectively). However, during this time high-quality bonds proved their mettle as diversifying investments--the Barclays U.S. Aggregate Bond Index of investment-grade U.S. bonds gained 5% on the year. But today, with fears of rising interest rates and a pullback of the Fed's asset purchases, many investors might be looking for alternative tools of diversification.

One obvious place to look is the alternative fund group, which encompasses funds employing several different trading strategies, including some commonly used by hedge funds. In fact, a recently released Morningstar Barron's Alternative Investment Survey found that advisors and institutions are increasingly turning to alternative funds as a way to gain access to these strategies. 

Alternative-fund types include long-short funds, in which managers try to capitalize on stocks they expect to increase or decrease in value; bear market funds, which focus on short-selling in anticipation of stock and/or market declines; and market-neutral funds, which use long and short positions in an attempt to reduce risk, among other strategies. Given that fees charged by alternative funds tend to be on the high side, especially compared with index funds, an alternative fund must do its job well to justify this high expense, and in many cases this means providing diversification.

Below are three alternative funds that come recommended by Morningstar's fund analysts due at least in part to their ability to help diversify a portfolio.

 Merger (MERFX)
This merger-arbitrage fund, which carries a Silver Morningstar Analyst Rating, buys stock in companies being acquired and shorts the stock of the acquiring companies. The fund faces new challenges as its asset base (now $4.6 billion) has grown and as merger activity in the wake of the financial crisis remains sluggish. Managers have introduced more deals into the portfolio (investing in 80 deals as of Feb. 28) and reduced position sizes accordingly, says Morningstar fund analyst Mallory Horejs. The fund has lost money in a calendar year just once in the past decade (2008), with annualized gains of 3.7% during that time period (through July 8). Its 1.27% expense ratio is below-average for a no-load alternative fund. The fund is not very tax-efficient, however, and is best-suited for a tax-advantaged account, such as an IRA.

 Robeco Boston Partners Long-Short Research (BPRRX)
This Bronze-rated long-short equity fund has only been around since 2010, but has delivered solid performance so far. Nine analysts control different sleeves of the portfolio, each one scoring stocks based on valuations (such as the price/book ratio), current business fundamentals (such as sales and earnings growth), and catalysts for change (such as earnings surprises). Analysts generate short ideas using a modified version of their long process (emphasizing fundamentally deteriorating growth stocks). The fund typically holds on to long positions for one to two years and short positions for six months to a year. Fees, at 1.79%, are above-average for an alternative no-load fund. The fund's low-volatility approach means it generally underperforms in rising markets.

 IQ Alpha Hedge Strategy
Replicating the performance of a broad index of hedge fund managers by using exchange-traded funds, this multialternative fund theoretically provides exposure to a swath of alternative strategies, being overweight in those its managers expect to outperform in the future. The fund attempts to provide superior risk-adjusted returns and lower correlations to traditional markets. It has outperformed during downturns while capturing some of the market's upside during rallies. The strategy's annualized 3.2% absolute return since its June 2008 inception (through April 2013) outpaces other hedge fund replicators that Morningstar tracks. Fees for the investor share class are 1.92%, higher than the average range for a no-load alternative fund.