Why You Don't Need "Alternative" Funds

So-called liquid alternative funds are the latest product Wall Street is pushing on retail investors. In 2013, about $40 billion of new investments flowed into the funds, up from $13 billion the previous year. The funds employ the kinds of strategies used by hedge funds, the less-regulated portfolios reserved for institutions and high-net worth investors. For example, in addition to owning investments outright, they'll go "short"—that is, bet on stocks or market indexes to go down.

Hedge funds have benefited from the mystique of exclusivity, and for a while boasted pretty great returns. Lately, though, their returns aren't all that impressive compared with what you can make just owning an S&P 500 index fund.

And mutual funds that mimic these strategies haven't exactly shot the lights out either. For instance, the average market neutral fund, which seeks to deliver gains in both good and lousy markets, has returned only around 2% a year over the past five years, according to Morningstar. That's about a tenth of the gains of the broad market during that time.

Financial sophisticates will call that an unfair comparison. Fine. But there's a reason besides performance to give clever-sounding hedge-like strategies a pass.

Consider this deal: I'll sell you this very nice antique vase. And I'll let you in on a secret, too. A magic fairy lives inside the vase, and will grant the owner a wish.

You do not really believe in magic fairies. But you might still buy the vase at the right price, because, hey, it's a nice vase. And if there's a chance about the fairy...

When you buy a regular stock fund, you're buying the vase. Most of what you get is the market's return. When the market goes up, most funds make money. And when the market goes down, most funds go down. Managers try to add a bit of performance on top, by making smarter picks than the competition. But for the most part, if you know how the S&P 500 did this year, you can make a pretty good guess about how your fund did. Even if your manager isn't all that skilled, you can still do okay so long as the market rises.

Buying a hedge fund, on the other hand, is like paying for the magic fairy without getting the vase.

The classic hedge strategy tries to eliminate or reduce the market factor. There are lots of ways to do this, including chasing illiquid assets or hopping among wildly different asset classes. In a long-short or market-neutral strategy, a manager might look at Apple and Microsoft and decide that Apple is a relatively better investment than Microsoft. By buying Apple and "shorting" Microsoft, the manager can in theory make money in both rising and falling markets, as long as Apple falls less than Microsoft in a down market, and rises more than Microsoft in an up market. (Many hedge strategies are head-spinningly more complex than this, but this captures the rough idea.) Investing in a hedge fund might reduce your market risk, but in return it bets more heavily on the manager's investment-picking skill.

Skilled managers aren't as elusive as magical fairies, but for practical purposes they may as well be. After fees, the vast majority of regular mutual funds don't beat their benchmark indexes. The reason is simple: Almost by definition, the average money manager must deliver the market's average, minus fees. Though some managers do outperform over time, it's hard to tell which ones were lucky and which ones have a skill that will persist over time.

It might be that managers of real hedge funds, who have some control over when money comes into and out of their funds, can use the extra flexibility they have to find an edge. But it is doubtful that in the world of mutual funds, which must be able to hand investors their cash back on any given day, that there is a special secret pool of skilled managers who only work for funds where shorting and leverage and other exotic tactics are allowed.