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A puzzle of arrowsAlternative funds are a mutual fund option to consider if you’re interested in other types of securities besides bonds, stocks or balanced mutual funds. These funds concentrate investments in non-traditional investment offerings and use alternative strategies to drive fund performance. While alternative funds aren’t necessarily right for every investor, they can be a useful tool for increasing diversification in an investment portfolio.

What Are Alternative Funds?

Alternative funds, or alt funds, are mutual funds or exchange-traded funds (ETFs) that rely on non-traditional investments and trading strategies to achieve their objectives. These funds offer investors exposure to investments beyond stocks, bonds or cash.

The range of investments you may find inside an alternative fund can include:

These are not the kind of investments you’d find in a typical mutual fund or ETF. Alternative funds use more complex investments and take a different approach to investing compared to the kind of funds an everyday investor may hold in their portfolio.

Alternative Fund Investment Strategies

Alternative funds can apply different investment strategies to produce returns. For example, an alternative fund can focus exclusively on one type of investment or stock market sector. These funds can also use hedging and leveraging to achieve their goals or focus on short-selling tactics to capitalize on market fluctuations.

An alternative fund can be broad or narrow in its approach to investing. For example, you can invest in funds that only use a single strategy or concentrate on a single investment while others combine different strategies together. These funds can have different goals as well. For example, some funds attempt to beat the market while others focus more on balancing risk for investors.

Pros and Cons of Investing in an Alternative Fund

Three investors consider an alternative investmentAlternative funds have both advantages and disadvantages that are important to understand before you add them to your portfolio.

Advantages of Alternative Funds

On the pro side, one of the chief benefits is diversification. Alternative mutual funds and ETFs can offer exposure to investments that you may not have considered before. A diversified portfolio can work to your advantage for minimizing risk while maintaining consistent returns.

Because these funds invest in alternative securities, they tend to have less correlation to the stock market. That can offer more insulation in your portfolio against market volatility. Real estate, for example, tends to be a consistent performer when stock prices are unstable because of economic uncertainty.

Alternative investment funds are also actively managed, which means you have the benefit of a professional fund manager’s knowledge and expertise on your side. A good fund manager can ensure that the fund’s objectives are being reached which benefits you as an investor.

Disadvantages of Alternative Funds

There are, however, some disadvantages associated with venturing into alternative mutual funds. For example, since these funds are actively managed that typically means paying more in fees. A higher expense ratio should be balanced against a higher rate of return over time.

Alternative funds and ETFs may also be less liquid and less transparent than other traditional mutual funds or ETFs. Liquidity is important because it determines how easily you could sell an investment if necessary. Transparency also matters because one of the most often-repeated pieces of investment advice is to know what you own.

If you’re unsure exactly what an alternative fund invests in or you have less liquidity for selling shares, that can directly impact your investment outcomes. For those reasons, alternative mutual funds may be more appropriate if you’re a more experienced investor, versus someone who’s just beginning to navigate the market.

How to Invest in Alternative Funds

letter blocksAlternative mutual funds and ETFs can be purchased inside a brokerage account. The range of options depends on which brokerage you invest with. But in terms of buying or selling them inside a taxable investment account, the process is essentially the same as buying any other mutual fund.

What’s more important is understanding how to evaluate alternative funds to decide which ones you should invest in. Keeping these criteria in mind can help when choosing which funds to add to your portfolio.

  • Minimum investment. While traditional mutual funds and ETFs allow you to buy in with a few hundred or a few thousand dollars, alternative funds can sometimes have much higher minimum investments. That’s important to know if you only have a limited amount of money to invest and you want to spread it across as many funds as possible.
  • Risk profile. Alternative funds are by nature riskier than other mutual funds. When comparing fund options, it’s important to look at the overall risk profile to see how it matches up with your individual risk tolerance and where it might fit into your portfolio as a whole.
  • Performance. Past performance doesn’t guarantee future returns but studying an alternative fund’s track record can give you an idea of how it’s reacted during different market cycles.
  • Cost. If you only look at one fee when comparing alternative funds, focus on the expense ratio. In the case of funds with higher expense ratios compare the cost to the fund’s returns to see if it’s justified.
  • Fund manager. The quality of the fund manager can make a significant difference in how well an alternative fund performs over time. Taking a look at the fund manager’s background, experience and investment style can give you an idea of what you can expect if you choose to invest.
  • Fund holdings and objectives. Lastly, look at what’s actually inside the fund and how it invests to make sure it’s aligned with your goals. If you’re interested in a real estate fund, for example, consider what type of properties the fund invests in and where they’re located. There can be a big difference between investing in a global real estate fund and a U.S.-focused real estate fund so it’s important to understand what you’re investing in as much as possible.

The Bottom Line

Alternative funds could be a useful addition to your portfolio if you’re looking for ways to diversify. But investing in them could mean increasing your portfolio’s overall risk profile. Before taking a chance on alternative funds, be sure to do your homework to understand what it is you’re investing in and how it may help you achieve your investment goals.

Tips for Investing

  • Consider talking to a financial advisor about whether investing in alternative funds makes sense for your financial plan. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool can match you with financial advisors in your local area in five minutes. If you’re ready to be matched with local advisors who can help you achieve your financial goals, get started now.
  • Understanding your risk tolerance and investing goals is a key part of any long-term financial strategy. Also, an investment calculator will help you to better visualize your goals and preferences.

Photo credit: ©iStock.com/sefa ozel, ©iStock.com/kate_sept2004, ©iStock.com/Gajus

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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