When Douglas Kobak was an adviser at a large brokerage firm, he suggested his wealthiest clients buy a hedge fund promising to be "a very conservative alternative to bonds." Then the credit crisis hit in 2008, the fund imploded and investors got 45 cents on the dollar -- as long as they promised not to sue.
Since then, mediocrity is more common than blow-ups. Hedge funds have lagged behind stocks while still charging fees of up to 2% of assets and 20% of gains. For the rich and their advisers, "the sex appeal of hedge funds has worn off," says Mr. Kobak, now head of Main Line Group Wealth Management.
Guess what the hedge fund firms are doing now?
Hunting for new, less skeptical customers.
While only those with at least $1 million are allowed to invest in hedge funds, anyone can buy a mutual fund with a hedge fund strategy. Unfortunately, these “alternative” funds come with the same disadvantages hedge funds have: high fees, inconsistent performance and strategies that take a PhD to decipher.
By starting alternative funds, mutual fund companies get a chance to bring in revenue they're losing to cheap index funds and exchange-traded funds. In a deal announced Nov. 18, Blackstone Alternative Asset Management is coming up with hedge-fund-like products for mutual fund company Columbia Management. They'll join 11 other U.S. mutual funds and ETFs classified by Bloomberg as "alternative," which together hold $68 billion in assets.
One in five of those assets is held by the largest fund, the MainStay Marketfield Fund (MFLDX). Started in 2007, it's one of the oldest alternative funds, and one of the most disappointing. After a good start from 2007 to 2009, the fund mostly matched the stock market in 2010 and 2011, and then lagged behind it in 2012 and 2013. This year, it has dropped almost 11%, a mirror image of the S&P; 500's 11.6% gain. A spokeswoman for New York Life Insurance Company, which owns MainStay, declined to comment.
Unreliable and disappointing performance is getting to be as common among alternative funds as among hedge funds. The Bloomberg Global Aggregate Hedge Fund index is up 2% year-to-date. The average return of an alternative fund open to all investors is 1.1%, behind the inflation rate. High-quality corporate bonds have returned 70% more than the median alternative fund over the last three years. The stock market has brought in eight times as much as alternatives.
And these blah results don't come cheap. The MainStay Marketfield Fund has been losing money while charging an expense ratio of 2.6% per year. That's pricier than 99% of all funds, though it's not as extreme among alternative funds. They charge an average of 1.74% per year, 20 times as much as the cheapest index funds. A spokesman for Ameriprise Financial, which owns Columbia, said the firm can't comment in detail about its plans while it waits for SEC approval.
But its 219-page prospectus does mention a 5.75% sales charge, or load fee, for "class A" shares. Share classes intended for retirement plans would lack that extra fee, but could charge other, annual fees. A spokesman for Blackstone didn't comment beyond citing an alternative mutual fund the firm started last year. Offered through Fidelity Investments, the Blackstone Alternative Multi-Manager Fund (BXMMX) has returned 3.1% this year, while charging an expense ratio of 3.14%.
Hiring an expert to help you choose among these alternative options adds to the expense. Like hedge funds, alternative strategies can be so complex that even many professionals don't understand them. "You don't really know what you own," says William Schretter, an adviser with Raymond James Financial. Columbia's prospectus mentions commodities, derivatives, merger arbitrage and other ways to “isolate and capitalize upon certain market-based inefficiencies.”
The typical sales pitch for hedge funds and alternative funds is that, by holding assets other than stocks and bonds, an investor reduces a portfolio's volatility. Theoretically, that cuts down risk while boosting returns.
That doesn't work when strategies turn out to be far riskier than their architects believed. And most alternative mutual funds and ETFs have never been tested in a crisis -- 62% were launched since 2010. If expert investors want to diversify, they have cheaper, simpler options, starting with hundreds of specialized ETFs. "It's not as if diversification is all that hard to get," says David Mendels, a planner at Creative Financial Concepts, LLC.
Choosing a hedge fund requires expertise and a healthy appetite for investing jargon. Alternative funds are being marketed to people who have neither. It's possible some of the new funds will prove worthwhile, Mendels says. More likely, they'll "end up being sold to the wrong people at the wrong time and for the wrong reasons."
This story first appeared in Bloomberg.com.