What Are Non Traditional Mutual Funds?

The latest issue of the Merrill Lynch ‘Advisor’ magazine (which I receive as a Merrill Wealth Management client) says:

“If you’ve been curious about hedge funds but felt they weren’t quite right for you, you might want to consider nontraditional mutual funds (NTMFs)”

Since I hadn’t heard of NTMFs yet, I thought that maybe you readers haven’t either. What are non traditional mutual funds, when did they come about and should you really consider them?

What are non traditional mutual funds?

In a nutshell, they seem to be mutual funds that allow non-accredited investors to buy into securities that don’t necessarily move in tandem with normal stock and bond investments.

Sources, such as Advisor Perspectives  and The Investment Lawyer newsletter indicate that there isn’t one particular kind of non-traditional mutual funds, but rather different ones that try to accomplish different strategies with different tools.

For example, one of these non-traditional mutual funds might try to avoid losing money when all other traditional type funds are doing so by using a hedging strategy. One of these hedging strategy tools is short selling. In short selling, the fund manager sells stock she doesn’t own in hopes that the price she gets now will be higher than the price she has to pay to buy the stock she already sold – she thinks the stock price will go down. Another of these hedging strategy tools is use of leverage. Our fund manager borrows money to buy stocks when the price is low and then pays it back when she sells the stock for a higher price, for instance.

Other funds might use different hedging strategies, named by Dianne M. Sulzbach and Philip T. Masterson in the 2008 article “Offering Alternative Investment Strategies in a Mutual Fund Structure: Practical Considerations” as:

“global macro, long/short, market neutral, fixed income and convertible arbitrage, event driven and emerging market strategies.”

Why use non-traditional mutual funds?

We all watched in chagrin in 2008 and again in 2009 when all parts of the stock AND bond markets went into a free fall – diving rapidly and ridiculously low. Many investors began to clamor for market investments that would hold their own in future recessions. The hope is that these funds, especially as part of a balanced overall investment allocation methodology will protect a portfolio against downside risk.

These funds allow sophisticated, yet not accredited, investors buy into alternative strategies. In addition, they usually have lower fees than an actual hedge fund and are more liquid (as hedge funds can freeze your investment for periods of time). Non-traditional mutual funds are also regulated by the Securities and Exchange Commission, which hopefully will reduce chances of a Bernie Madoff type situation.

When did non-traditional mutual funds get started?

Breaking with Tradition: Mutual Funds Offer an Alternative Route – a white paper from Goldman Sachs Asset Management says:

“In the late 1990s and early 2000s, alternative satellite mutual funds employing non-traditional strategies such as long/short, market neutral, and bear market/inverse began to emerge, and the first decade of the millennium has seen a proliferation of these types of funds.”

Investor education has created more sophisticated investors, which are needed to engage in trading these non-traditional mutual funds and changes to capital markets have allowed previously non-tradable things such as real estate and direct commodities to be traded in a liquid manner.

Should you consider non-traditional mutual funds?

In the Wells Fargo “A guide to investing in mutual funds”, the authors highlight that these types of funds are not suitable for all investors:

They are designed for sophisticated investors who:

• Understand the risks associated with the use of leverage and other complex strategies
• Understand the consequences associated with daily leveraged investment results
• Accept the risks and volatility associated with investing in complex mutual funds
• Intend to actively monitor and manage their investments on a daily basis

That same guide stresses that these types of funds do not work for a buy and hold investor and that they are speculative trading. Additional cautions included the below statement:

“Generally, non-traditional mutual funds anticipate that investors will frequently redeem or exchange shares of the funds, which may cause the non-traditional mutual funds to experience high portfolio turnover, resulting in higher transaction costs. Large movements of assets into and out of the funds may negatively impact a fund’s ability to achieve its investment objective. As a result, these products are subject to a number of risks that transcend those of traditional mutual funds.”

Yet, if you are a sophisticated investor, understand the funds, the strategies and the risks involved, you may be part of the crowd that is driving creation of these non-traditional mutual funds.

According to the Goldman Sachs white paper noted above:

“Individual investors have also become increasingly sophisticated and comfortable with investment techniques such as shorting, leverage and the use of derivatives. As a result, mutual fund managers have begun to offer strategies with more relaxed constraints, and some investors have responded, now able and willing to capitalize on techniques long used only in the institutional marketplace. Additionally, developments in the capital markets have enabled liquid, tradable exposures to asset classes such as real estate and direct commodities that were previously either un-investable or illiquid.”

If you do decide to look into trading these types of mutual funds, check out the Morningstar mid-year review of non-traditional mutual funds  in 2012 and remember that I am not an investment professional. Do your own research and consult your own advisers before acting!

What have you heard about non-tradition mutual funds?  What would it take for you to consider investing using them?