Image credit: Pieter Bruegel the Elder, “The Blind Leading the Blind” (1564), Museo di Capodimonte, Naples, via Wikimedia Commons
By Jason Zweig | June 6, 2014 1:06 p.m. ET
You probably aren’t going to drive by a billboard advertising a hedge fund anytime soon, or get pitched private-equity funds by email, but that doesn’t mean these investment ideas aren’t popular—or highly marketable.
Last year, the U.S. Securities and Exchange Commission relaxed rules that have long restricted hedge funds and other exclusive investments from marketing themselves directly to the public. Some predicted that, as a result, these firms would put ads in elevators and handouts in dentists’ offices, though “no one’s doing this,” says Brian Daly, a partner at Schulte Roth & Zabel law firm who advises hedge funds on complying with regulations. Most private funds, he says, don’t want to subject themselves to the extra scrutiny that would come with marketing openly to the public.
Nevertheless, private-equity funds, commodity pools, venture capital plays and other “alternative investments” are hotter than Texas asphalt on an August afternoon. Hedge funds alone raked in $41 billion—in a single month—earlier this year, according to eVestment, which tracks this market. And so-called liquid alternatives—mutual funds that invest in similar strategies—took in $103 billion over the past year, or 79 percent of all the stock and taxable-bond money gathered by the mutual-fund industry over that period, estimates Lipper, a fund-research firm.
Financial advisers are telling wealthy clients that the stock market is overvalued, bond yields are microscopic and geopolitical risks are multiplying—so it is imperative to diversify with managers who know how to control risk and produce returns unlike those on U.S. stocks. But the strategies used by alternative funds can be dizzyingly complex, with a panoply of interest-rate swaps, short sales or bets that stocks will go down, and swarms of trades in currencies, options and commodities.
Decades of research has shown that predicting whether even the most generic mutual fund will beat the market is fiendishly difficult. So forecasting whether an arcane alternative fund will perform as advertised is nearly impossible. Indeed, a recent survey by Natixis Global Asset Management found that only 31 percent of financial advisers felt they understood alternative funds “very well” and that 53 percent believed the funds were “often too complex to explain.” Nevertheless, almost all advisers surveyed—89 percent—said they invest at least part of their clients’ money in them. This, to some, might seem like the blind leading the wined-and-dined.
Determining whether an alternative fund is accomplishing its objective can be difficult. Consider a fund with the explicit goal of doing well when U.S. stocks do poorly. Evaluating it when the market is booming—like last year, when domestic equities gained 32 percent—is tricky. If an alternative fund went up 28 percent, was that good because an investor shouldn’t expect it to match a roaring market—or bad because the fund may have taken excessive risks to keep up?
The smart investor will ask questions to tease out how well an adviser understands what he’s trying to sell and when the fund tends to perform well or not. These days, many advisers engage in so-called benchmark switching, meaning they may compare the fund with one market measure before you buy it and then—after the fund underperforms that yardstick—switch to another, more-flattering comparison. “It’s extremely common, and most clients aren’t even aware it’s happening,” says Robert Martorana, a portfolio manager at Right Blend Investing.
To avoid this trap, insist that your adviser name the market benchmark he thinks the fund should be measured against—and then monitor whether he ends up moving the goalposts later. In the end, though, what an adviser shares about an alternative fund may say more about him than about the fund itself.