How are alternative mutual funds different?

Just like traditional mutual funds, alternative mutual funds are registered securities. In fact, they have all the same regulations, compliance and governance as traditional mutual funds, and sometimes, even more. Where they differ, however, is in the manner in which the capital is invested. Alternative mutual fund managers use a broad range of tools and techniques available to them and they aim to use those to seek to deliver returns that are more efficient from a risk and return perspective.

Here are some of the key tools and techniques used by alternative mutual funds that are typically not used in traditional mutual funds:

Shorting
Derivatives
Leverage

Shorting

Most traditional mutual funds only buy and hold securities until they are no longer desirable for the portfolio. In contrast, alternative mutual funds are allowed to short sell a security. In other words, a portfolio manager who finds an overvalued security can sell that security without owning it first. Then, at a future point in time, the portfolio manager can buy that security back at a lower price, if available, to generate a profit for the portfolio.

This technique of shorting allows a portfolio manager to not only potentially profit from his or her ideas about which securities are undervalued, but also from his or her ideas about which securities are overvalued.

Derivatives

Derivatives, such as futures and options, give portfolio managers the opportunity to efficiently manage risk and enhance returns. Derivatives are financial instruments whose value changes based on the changes in the value of another financial asset, such as a basket of stocks or bonds, the value of currencies or the level of interest rates. These instruments give portfolio managers the ability to quickly and efficiently gain exposure to these assets or hedge against potential changes in their value.

Leverage

Leverage allows portfolio managers to potentially enhance portfolio returns and to more effectively mitigate portfolio risk. It can be used to purchase a greater level of assets for a fund than would otherwise be possible, or hedge specific exposures in a portfolio against potential declines. Leverage can be obtained through the use of derivative instruments or through borrowing, and in both instances the use of leverage is regulated.

The use of these investment techniques and tools allows alternative mutual fund managers to be more flexible in their mandates, and invest their portfolios without the constraint of a benchmark. As a result, their performance objectives tend to focus on delivering absolute returns rather than benchmark relative returns.

There are a few defining characteristics of alternative mutual funds:

  • Have a low correlation to the equity or fixed income markets, meaning that they are likely to provide diversification benefits to your portfolio.
  • Hold both long and short positions in securities, thus providing a potential buffer when markets decline.
  • Use leverage to hedge risks or put more of your money to work, thus reducing risk or enhancing returns.
  • Use derivative instruments to efficiently implement their ideas, thus allowing portfolio managers to be nimble when markets move.
  • Are unconstrained from common benchmarks such as the S&P 500 Index or the Barclays Aggregate Bond Index, giving managers more opportunity to add value.