Institutional investors are increasingly turning to mutual funds over hedge funds for strategy diversification. Just over a quarter, 26 percent, of institutions use hedge funds for exposure to long-short strategies this year, compared to 61 percent in 2010, according to a survey released this week by Morningstar and Barron's.
Long-short mutual funds take mostly long positions, buying investments they believe will go up, while hedging their bets with a smaller amount of short positions, or investments they think will go down. There are other types of alternative strategies -- for instance, market neutral strategies that take long and short positions but avoid stocks to lessen volatility. In general, alternative investment strategy funds "provide a smoother ride over time," says Nadia Papagiannis, CFA, director of alternative fund research at Morningstar.
During the events of 2008, institutional investors found themselves stuck in illiquid, highly leveraged hedge funds that only a year or two before had returned outsized returns.
"In 2008, hedge funds delivered high losses. Investors were stuck with illiquid investments they had to pay management fees on but couldn't get out of," says Papagiannis.
Mutual funds offer liquidity and transparency, plus lower fees for similar strategies. "When you are getting double-digit returns, it's OK to pay 2 percent management fees and a 20 percent performance fee. But with mediocre returns, that eats away at benefits. Plus, if you can find something with lower costs, that is something that as a fiduciary, you have look at," she says.
The average expense ratio of the long/short equity fund category on the Morningstar website is 1.96 percent.
Advisers to small investors are also interested in the risk-management benefits of alternative strategies. For investors, allocating a portion of their portfolio to an alternative strategy fund helps cushion the downside when big stock market drops happen. That downside cushion means less return on the upside as well.
"In order to build wealth over time, you need to have a little bit of a smaller upside and a lot smaller downside. That way, you can build wealth more effectively over time rather than having a couple good up years and then big down years," says Papagiannis.
Investors scared of living through another stock market drop like the one in 2008 and 2009 may want to consider incorporating some strategies that behave differently than the rest of their investments.
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Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.