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Alternative funds: You have been warned about their differences

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You may have read sales pitches for alternative funds — an exotic new type of mutual fund. Before you consider buying any of these, you should be aware that they aren't your father's mutual funds; they're a different animal altogether.

The Financial Industry Regulatory Authority (FINRA), Wall Street's self-regulatory organization, has issued an alert to consumers describing alternative funds' "strategies" as being "on the complex end of the spectrum."

Where there's increased complexity, there's usually significantly increased risk — and alternative funds are no exception. Regular mutual funds own primarily what are known as traditional investments: stocks, bonds and money market investments (referred to as cash). As their name implies, alternative funds additionally own significant proportions of alternative investments — those other than stocks, bonds and cash.

Like all mutual funds, alt funds, as they're known, are publicly offered and thus registered with the U.S. Securities & Exchange Commission. This status may lead some consumers to equate them with traditional mutual funds. But you should be aware that they are vastly different. These differences can amount to substantially more risk than you may be comfortable taking.

In addition to traditional investments, some mutual funds hold proportions of alternative investments — typically, REIT (real estate investment trust) securities. Including this type of alternative investment may actually decrease the overall risk of your portfolio at times, because values often don't move in the same direction as those of typical stocks and bonds.

By contrast, alt funds own far larger proportions of alternative investments, which can actually increase risk. These funds may also own real estate, but they also often invest in commodities, leveraged loans and shares of small private companies whose risks are unknowable because they're publicly traded.

Also, they can invest in derivatives — often horrendously complicated contracts whose value to the investor is determined by fluctuations of the underlying assets. Common derivatives include options (a contract to buy or sell a stock in the future at a set price) and swaps (exchanging one security for another in an attempt to gain advantage). Some derivatives are little more than outrageously complicated bets — for example, betting on the weather by trying to predict how many sunny days there may be in a given region during a set period. Wall Street firms employ mathematicians and probability experts to concoct such complicated investments in ways that line their pockets, not yours.

As if that weren't enough, alt funds can also engage in short selling. This is extremely risky; it's when speculators attempt to profit from an anticipated price decline in a security. The short seller "borrows" shares from a broker, later "returns" the shares by buying them on the open market at a price potentially lower than when the deal was struck and keeps the difference in price.

Alt funds also may own distressed bonds, which pose significant risk from a high potential for default. Also, if an alt fund owns distressed private companies and these companies go under, that could significantly impact the value of your investments. Do you really want to own a distressed company you know nothing about? If not, carefully examine the holdings of any alt fund before you give them your money.

What's more, some alt funds own currency investments, which can be tricky and mercurial, changing in value rapidly with economic impact of government policy and politics in foreign nations.

These same types of investments are also owned by hedge funds — widely regarded as expensive, speculative investments — but FINRA points out in its alert that alt funds and hedge funds have some key differences. Most of these differences stem from the fact that, as mutual funds, alt funds are regulated by the SEC and hedge funds aren't.

Because of SEC regulations, alt funds must limit their holdings of illiquid investments (those that investors can't immediately cash out). Also, the SEC puts ceilings on how much alt funds can invest in any one issuer and requires they make pricing information available to investors on a daily basis. This doesn't exist for hedge fund speculators.

FINRA recommends consumers carefully assess various risk factors stemming from an alt fund's speculative strategies. For example, if there's a lot of turnover of assets in the fund, this can substantially increase trading costs, which can mean lower net return — if any.

Yet what about the risks involved in alt funds' specific holdings? Isn't that the larger issue? If the majority of an alt fund's holdings are inherently speculative, committing your own money to such a complex investment may be foolish gambling instead of wise investing.

Tim Decker, a fee-only financial planner, is president of ISI Financial Group in Lancaster. He is the author of "The Sleep-Well-At-Night Investor" and host of the radio program "Financial Freedom," which airs at noon Saturdays on WHP-AM 580. Contact him at www.isifinancialgroup.com.

This content is based upon information believed to be accurate by ISI Financial Group Inc. However, it should not be relied upon for legal or accounting purposes. Past performance is not indicative of future performance. Investments involve risk, including the possible loss of principal. Always seek professional advice before making any financial or legal decisions.

Write to the Editorial Department at editorial@cpbj.com

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