Watch Out for Alternative Investments

If it sounds too good to be true, it probably is too good to be true. That age-old maxim is something to keep in mind if you are considering investing in alternative investments such as liquid alternative mutual funds, leveraged ETFs, non-traded REITs, structured notes or unconstrained bond funds. As Kirsten Grind observes in Five Popular—but Dangerous—Investments for Individuals, these sophisticated investment vehicles, popular among investors seeking protection from perceived market dangers, could have a small place in your portfolio. However, they must be used correctly – and with great caution.

While high fees as well as a lack of liquidity and short track record may present roadblocks, many investors should not invest for one simple reason: They don’t understand the products. When it comes to your portfolio, following the crowd is a mistake. Yes, for example, liquid-alternative funds are growing in popularity. As Grind notes, investors poured $40 billion into them in 2013, up from $14 billion the previous year. This year through June, according to Morningstar, they have taken in $14.6 billion.

Promotional materials for these investments will tout diversification benefits and the ability to capture some of the upside of stock returns in good markets while being protected in down markets. But the strategies often are too complicated for the average investor to understand and there is little evidence that they deliver.

I’m particularly concerned by the popularity of “unconstrained” bond funds. These “go anywhere” funds are attractive to investors worried about rising interest rates. Grind shares the Morningstar data that through June, the nontraditional bond fund category, which mostly encompasses unconstrained bonds, has seen net inflows of $20.7 billion, increasing total assets to $150.3 billion, up from $99 billion during the same period in 2013. And more than 87 such funds exist today, up from 37 four years ago.

Unlike traditional bond funds, which generally hold highly rated corporate bonds and U.S. Treasuries, unconstrained bond funds can hold everything from cash to high-yield junk bonds. They also can use derivatives such as Treasury futures and interest-rate swaps to attempt to manage interest rate risk. Yes, derivatives.

In 2013, the category returned 0.29%, compared with a loss of 1.4% for traditional bond funds, according to Morningstar. But, importantly, those gains came from far riskier investments. As Grind shares, nontraditional bond funds hold 36% of their portfolios in high-yield bonds, compared to only about 11% in traditional bond funds. That’s a big difference. It’s important to dig into details like this so you understand not only what you could gain with these investments, but what you could lose.

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