Your Finances: How to evaluate alternative mutual funds

Ever since they were badly burned in the Ever since they were badly burned in the 2008-2009 stocks and bonds debacle, investors have been pouring money into so-called "alternative" mutual funds, often at the behest of financial advisers who say those funds will protect them from the fire next time. Photo Credit: iStock

advertisement | advertise on newsday

Ever since they were badly burned in the 2008-2009 stocks and bonds debacle, investors have been pouring money into so-called "alternative" mutual funds, often at the behest of financial advisers who say those funds will protect them from the fire next time.

But it is too soon to tell whether most of these funds will work as suggested.

"Alternatives" is a catchall category that can include everything from real estate partnerships to mutual funds that mimic hedge funds or use arcane hedging strategies. Most typically they are the latter; advisers promote these funds as vehicles that can reduce risk and boost returns.

Alternatives are controversial. The vast majority of these funds sprung up in the aftermath of the 2008-2009 sell-off and don't have enough of a performance history for us to judge how they actually would perform during bad times. They certainly have underperformed the runaway U.S. stock market in 2013, but they are not meant to beat stocks, they are meant to cushion bear markets or squeeze better-than-bond returns out of income investments.

So, without those long performance histories, how should you evaluate an alternative recommendation?

Here are some questions to ask your adviser.

Why? Why is this fund being suggested? Is it to calm your portfolio during bad times or to add extra income? The kinds of funds used for one are not the kinds used for another. In the last year, the most popular alternatives have been bond alternative funds, which allow managers to invest in foreign bonds and low-rated bonds and derivatives and other products to win bigger returns than low-interest-rate bonds.

advertisement | advertise on newsday

How? How will the fund accomplish its stated goal? Require your adviser to explain the strategy to you well enough so that you understand it. Ask: How did that strategy perform in 2008 and 2009?

Who? If you're being sold an alternatives fund that has only been around for a year or two, find out who the manager is and what she or he did before. Perhaps they ran a hedge fund. How did it do in 2008 and 2009? What kind of reputation and performance history does the fund company have?

How much? Alternative funds can be expensive. The average investor would pay 1.88 percent a year in expenses, according to Morningstar. You can buy a risk-mitigating short-term bond index fund for around 0.20 percent a year and a return-boosting stock dividend fund for roughly 0.3 percent a year. They aren't directly comparable, of course, but it's worth asking how much more you'll get for your money.

You also may be interested in: