Could non-traditional mutual funds help diversify your portfolio?

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Consider non-traditional mutual funds to help diversify your portfolio
Experienced investors looking at alternative investments to diversify their portfolio and manage risk may want to consider this relatively more liquid option.
From the Merrill Edge Minute e-newsletter.

Key points

  • Non-traditional mutual funds offer strategies typically associated with hedge funds but are available to a wider group of investors
  • These funds may help address some portfolio risks by seeking to provide returns that don't correlate with those of the equity or bond markets
  • Non-traditional mutual funds tend to have lower fees and be more liquid and more transparent than traditional hedge funds
  • Since they are mutual funds, non-traditional mutual funds are subject to regulations that limit their use of some investment techniques that hedge funds are free to use, so they're an imperfect substitute for hedge funds
  • Learn how our Mutual Fund Screener can help you find non-traditional mutual funds
Institutional investors and high net worth individuals have long used hedge funds as part of their portfolio diversification strategy as they seek to increase their risk-adjusted returns. Now, greater numbers of sophisticated investors can potentially pursue those same goals with the use of what are known as non-traditional mutual funds (NTMFs). In particular, the ups and downs of these funds have historically tended to be inversely correlated with the performance of traditional stocks and bonds. Understanding how these funds work could help you determine if they might have a place in your overall investment portfolio.

Why they're popular

After the financial crisis of 2008, many investors were looking for ways to diversify their portfolios and reduce their dependence on the stock and bond markets. Meanwhile, investors in hedge funds wanted greater transparency and liquidity — characteristics that such investments tend to lack.
These converging interests helped fuel demand for non-traditional mutual funds. Assets in these types of funds, which Morningstar categorizes as "alternative" mutual funds, grew 800% between 2005 and 2014 — and more than doubled between the beginning of 2012 and the end of 2014, according to data from Morningstar.
Non-traditional mutual funds have risen in popularity since 2012
Source: Morningstar Direct: MLWM Investment Management & Guidance. Data as of Dec. 31, 2014.

What are the potential benefits of non-traditional mutual funds?

Non-traditional mutual funds exhibit several characteristics that could help complement a portfolio of traditional investments. NTMFs are similar to hedge funds in that they may:
  • Invest in a broader range of markets than traditional funds do
  • Make concentrated investments in fewer holdings
  • Use leverage
  • Employ short-selling (trading borrowed shares to profit when prices drop)
  • Invest in securities that are less liquid than those held in traditional funds
There are, of course, some tradeoffs. Since NTMFs are mutual funds, they're subject to regulations that limit their use of some investment techniques that hedge funds are free to use. The result of this could be performance that more closely correlates with that of the overall market than with hedge fund performance, making them an imperfect substitute for hedge funds.

A selection of carefully chosen non-traditional mutual funds could provide your investment portfolio with exposure to the potential benefits of hedge-fund-like strategies, but in a more liquid, regulated and convenient fashion.

Like hedge funds, non-traditional mutual funds can offer higher return potential but also higher loss potential. Hedge funds, however, may require investors to lock up their assets for extended periods, are only lightly regulated and often don't provide full information about their holdings.
NTMFs tend to offer these attributes that appeal to many investors:
  • Daily liquidity at the current net asset value, which may be higher or lower than the original investment
  • Transparency comparable to that of traditional mutual funds
  • Lower investment minimums and less stringent eligibility requirements than hedge funds
  • Generally lower fees than hedge funds
  • More efficient tax reporting than hedge funds
  • A broad range of opportunities to possibly influence risk and returns, as well as reduce losses in down equity markets

Using non-traditional mutual funds in your portfolio

The strategies of NTMFs tend to fall into three broad categories:
  1. Credit-oriented — seeking stability and consistent returns. Such NTMFs might take long and short positions in credit instruments or equities or take a "relative value" approach, attempting to limit exposure to financial market movements.
  2. Equity and growth-oriented — looking for growth and capital appreciation. NTMFs in this category may take long and short equity positions, invest in emerging markets or look for "event driven" opportunities.
  3. Diversification-oriented — seeking to provide exposure to non-traditional asset classes. Using managed futures, commodities or "global macro" approaches, NTMFs of this type might help to further diversify your portfolio into types of assets expected to have low correlation to the equity or bond market.
You might choose to use NTMFs in several different ways; for example, you might add long/short equity strategies to a traditional equity allocation to help reduce portfolio volatility. Or you might consider non-traditional bond strategies to address a portfolio's sensitivity to interest rates. Note, however, that while that risk may be reduced, other types of risks, such as those resulting from increased credit exposure, could rise.
A selection of carefully chosen non-traditional mutual funds could provide your investment portfolio with exposure to the benefits of hedge-fund-like strategies, but in a more liquid, regulated and convenient fashion. If this kind of diversification might have a place in your portfolio, consider making use of non-traditional mutual funds.
Next steps

Alternative Investments, such as hedge funds and private equity, can result in higher return potential but also higher loss potential. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk. Some or all alternative investment programs may not be suitable for certain investors.

Non-traditional mutual funds (NTMFs) are intended to offer investors exposure to hedge fund strategies, but in a more liquid format with relatively low minimums. Each of the funds is registered under the 1940 Act and is subject to 1940 Act restrictions. While NTMFs can offer diversification within a relatively liquid and accessible structure, it is important to understand that they may be imperfect as a hedge fund substitute.

Non-traditional funds (NTFs) are mutual funds and exchange-traded funds that are classified as alternative investments because their principal investment strategies utilize alternative investment strategies or provide for alternative asset exposure as the means to meet their investment objectives. Though the portfolio holdings of NTFs are generally made up of stocks and bonds, NTFs may also hold other asset classes and may use short-selling, leverage and derivatives. While the strategies employed by NTFs are often used by hedge funds and other alternative investment vehicles, unlike hedge funds, NTFs are registered with the SEC and thus subject to a more structured regulatory regimen and offer lower initial and subsequent investment minimums, along with daily pricing and liquidity. While these investment vehicles can offer diversification within a relatively liquid and accessible structure, it is absolutely essential to understand that because of this structure, NTFs may not have the same type of non-market returns as other investments classified as alternative investments (such as hedge funds) and thus may serve as an imperfect substitute for such other investment vehicles. The risk characteristics of NTFs can be similar to those generally associated with traditional alternative investment products (such as hedge funds). No assurance can be given that the investment objectives of any particular alternative investment will be achieved. Like any investment, an investor can lose all or a substantial amount of his or her investment. In addition to the foregoing risks, each alternative investment vehicle is subject to its own varying degrees of strategy-specific or other risks. Whether a particular investment meets the investment objectives and risk parameters of any particular client must be determined case by case. You must carefully review the prospectus or offering materials for any particular fund/pooled vehicle and consider your ability to bear these risks before any decision to invest.

For more complete information on any non-traditional mutual fund, please request a prospectus and/or, if available, a summary prospectus and read it carefully. Before investing, carefully consider the investment objectives, risks, and charges and expenses of the fund. This and other information may be found in the fund's prospectus and/or summary prospectus. Read the prospectus and/or summary prospectus carefully before you invest.