Volatility, low interest rates likely to boost alternatives despite lag

Seems like investors can’t get enough of a bad thing. Despite the generally dismal performance of alternative investment funds, investors continued to pour money into them in 2011. And if the volatility of the stock market continues and Treasury bond yields remain low, count on investors to keep placing bets on such funds in 2012.

The average 2011 return of seven categories of alternative funds tracked by Morningstar Inc. was -4% as of Dec. 21. That’s substantially worse than the 0.93% return in the S&P 500 for the same period, and much worse than the 7.3% return on the Barclays Capital U.S. Aggregate Bond Index.

Market-neutral funds, which seek to limit market risk and achieve returns from the convergence or divergence of asset prices, were the best-performing category last year, with a -0.21% return through Dec. 21, according to Morningstar.

Commodities trading has been one of the hottest categories in the alternatives sector over the past few years — in part because it fared well during the financial crisis. But managed-futures funds were the second-worst performing category with a -6.89% return through Dec. 21. (Bear market funds had the worst return.)

Of course, 2011 was brutal for commodities-trading advisers, largely due to the schizophrenic markets. With the price of everything from stocks to gold to oil and other commodities careening wildly, there were few trends advisers could discern.

TOUGH 12 MONTHS

“It was a very difficult year for the industry,” said David Kavanagh, president of Dearborn Capital Management, which launched a fund of managed futures funds in March with $60 million in assets. The fund lost 0.6% through the end of November.

“Dramatic reversals of historic proportion have been the trademark of 2011,” he said.

None of the other alternative categories tracked by Morningstar — currency, long/short equity, multistrategy alternative and nontraditional bond — produced positive returns through Dec. 21.

And yet, investors continued to pour money into mutual and exchange-traded alternative funds, which employ hedge-fund-like strategies with low correlations to stocks and bonds.

Through the end of October, new money flows into open-end mutual funds employing alternative strategies totaled $22.5 billion, according to data from Morningstar. Another $12.5 billion poured into alternative ETFs. That compares with $43 billion and $18 billion, respectively, in all of 2010.

More than $37 billion has flowed into nontraditional bond funds, which go long or short on a wide range of fixed-income products, in the last two years.

“We’re still seeing huge flows into the space this year,” said Mallory Horejs, an alternative-investment analyst at Morningstar.

The performance of hedge funds also has been weak.

The industry had its fourth-worst quarterly performance in the third quarter, according to data from Hedge Fund Research Inc. The HFRI composite index was down 6.2% for the quarter and just seven of the 29 strategy and regional indexes tracked by the firm had positive returns for 2011 through the end of November.

Despite the poor performance, however, demand for liquid alternative funds continues to be strong, prompting hedge funds to launch their strategies in Investment Company Act of 1940 fund formats and traditional fund managers to offer up new alternative funds.

As of mid-December, 68 alternative mutual funds had been launched in 2011, bringing the total to 299. There also now are 434 ETFs and exchange-traded notes classified as alternative, with 114 launched in 2011. At the end of October, assets in alternative ETF mutual funds totaled $120 billion, while exchange-traded funds and notes accounted for $159 billion in assets.

“There’s been a huge level of interest from financial advisers,” said Brian Jacobs, chief executive of Hatteras Funds, which manages four alternative mutual funds and the $1.5 billion Hatteras Multi-strategy Fund, available to institutional investors.

“The market has moved faster than the advice and guidance on how to use these products,” Mr. Jacobs said.

Indeed, the soaring demand has arguably led to a lot of low-quality supply and resulting bad performance.

“The performance has been surprisingly disappointing,” said Ms. Horejs. “In part, it’s a result of hedge fund managers not being able to operate their strategies as effectively in a 1940 Act format, and traditional managers not having the experience with these strategies.”

What’s the outlook for alternative investments in 2012?

With uncertainty and volatility in the markets likely to remain high in the coming year, it’s a good bet the interest in alternatives will also remain high.

“The theme of risk aversion is still prominent with investors,” said Ms. Horejs. “I expect money to continue flowing into nontraditional bond and multistrategy funds.”

Kenneth Heinz, president of HFRI, thinks global macro funds trading assets and currencies based on evolving events in the global economy are likely to be popular with institutions and large investors.

The unresolved situation in Europe and the anemic U.S. economy are likely to keep markets on edge for some time. That being the case, investors and financial advisers will continue looking to alternatives to help reduce their risk.

“Dabbling in alternatives won’t do it,” said John Cadigan, national sales manager of Direxion Funds. “You need a 10% allocation or better for it to have an impact on your portfolio. As people look at their equities and fixed-income exposures, I think we’ll see the alternatives dialed up to a 20% to 30% allocation.”

If so, investors will hopefully be rewarded with a little better performance.

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