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What’s the SEC’s Problem With Alternative Mutual Funds?

Hedge-like funds fall under the regulatory spotlight

   
What’s the SEC’s Problem With Alternative Mutual Funds?

The Securities and Exchange Commission has opened a broad examination of alternative mutual funds, including large investment firms such as BlackRock (BLK) and AQR Capital Management, LLC, and some smaller companies that previously did not offer mutual funds.

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If the term “alternative mutual funds” doesn’t sound familiar, don’t worry — while they’re suddenly more popular now than before, many individual investors still haven’t come across them.

Alternative mutual funds are like hedge funds for the small investor. They employ hedging strategies, such as going short on stocks or using options and derivatives or similar ways to bet against the market.

However, packaging and marketing them in the form of mutual funds makes them accessible to a much larger investor community.

A typical objective of alternative mutual funds is to maintain a market-neutral position, which often results in bond-like returns in a bull market for stocks and low to near-zero returns when stocks turn negative. Thus, investors might be more attracted to these hedge-like funds if they think a new bear market is imminent (to hedge their traditional stock mutual funds).

Why Is the SEC Probing into Alternative Mutual Funds?

The SEC has given no explicit indication that their examination or “sweep” of fund companies offering alternative mutual funds is anything more than an information-gathering investigation.

However, it’s not difficult to read between the lines and see that the SEC has some concerns about the $40 billion of investor assets that flowed into alternative mutual funds in 2013 and nearly $17 billion through July 2014. This growth is on pace to more than double the average inflows in these funds for the three previous years in 2010, 2011 and 2012.

It also might be of concern to the SEC that the average investor might not fully understand the objectives and holdings of alternative mutual funds … but still might be attracted by the lure of hedging strategies, largely inaccessible to the broader public in recent years.

Also, according to The Wall Street Journal’s report, there are no specific mutual funds named in the SEC examination as of this writing. However, we can take a look a few alternative mutual funds — one from BlackRock and one from AQR Capital Management — to see what the SEC might be looking at soon.

Blackrock Global Long/Short Equity (BDMAX)

Also offered in C shares, institutional shares and load-waived shares, Blackrock Global Long/Short Equity Investor A Shares (BDMAX) invests in a balance of stocks of both long and short positions, taking directional bets in the attempt of achieving positive returns when stocks are headed higher, but minimize or prevent losses when stock prices take a decided move downward.

Like many alternative mutual funds, BDMAX has a brief track record (inception 12-20-2012) but it appears to be performing as designed. The one-year return is 4.3%, which places it above-average in its market-neutral category but far behind the S&P 500, which gained 17.3% in the past 12 months. Year-to-date BDMAX is down 1%, whereas the S&P 500 is up 6.7%.

Testimony to the easy access to today’s new alternative mutual funds, BDMAX has a low $1,000 minimum initial investment. But the expense ratio is high at 2.18%.

AQR Managed Futures Strategy (AQMNX)

AQR Managed Futures Strategy N Shares (AQMNX) has a longer track record than most alternative mutual funds (inception Jan. 6, 2010) and a reasonable expense ratio, but minimum initial investment amounts are out of reach for most investors.

The fund’s net expense ratios are 1.25% for institutional shares and and 1.5% for investor shares, which is much lower than most alternative mutual funds, typically above 2%. The fund demands high minimums ($1 million for investor shares and $5 million for institutional shares), but they’re often waived for advisors, opening the door for more investors to access AQMNX.

The AQMNX objective is to seek positive absolute returns. To do this, it invests primarily in a portfolio of futures contracts, futures-related instruments and swaps.

To compare to the broader stock market, AQMNX is down 6.5% and the S&P 500 is up 6.6%. It is important to note, however, that AQMNX — as well as the vast majority of other alternative mutual funds — does not correlate with major market indices.

By design, they can move in nearly the opposite direction as stocks held in long positions.

But perhaps this latter point is the primary cause for the SEC’s concern — that the average investor may not fully understand the nature of alternative mutual funds.

As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.


Article printed from InvestorPlace Media, http://investorplace.com/2014/08/alternative-mutual-funds-sec/.

©2014 InvestorPlace Media, LLC

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