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Arrow Funds' Alternative Plan

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Joe Barrato is frustrated with the use (or rather, lack) of alternative investments and hedging strategies in the mutual fund and ETF space.

“If you look back at alternative and tactical assets 10 years ago in the mutual fund and ETF industry, less than 1% was allocated to those strategies,” he says. “Fast-forward to today and you’re at less than 5%.”

Sure, investment advisory firms have made use of the strategies for quite a while, but there’s a void in the fund space still waiting to be filled, and Barrato’s made it his mission to fill it.

It’s easy to see from where his passion for innovation stems. Barrato is a Rydex|SGI alum, having served as the firm’s director of product development. He’s also a former financial examiner for the Federal Reserve Board of Governors, so he’s sure to avoid any MedCap/Provident-style debacles in the products he brings to market.

In 2006, discouraged by constantly being told “no” by a firm once revered for its foresight, Barrato (along with two other Rydex colleagues) struck out on their own, forming Arrow Funds. More former Rydex employees caught wind of what they were doing and soon followed. Today, the firm has 23 employees and $750 million in assets.

“We know a lot of people in the business from our days at Rydex,” Barrato says. “There are a lot of really smart people that worked there and have since left. As we grow and position ourselves to bring key members to our team, we like to work with people we already know.”

The Arrow DWA Balanced Fund (DWAFX) is the firm’s flagship product with $348 million in assets. In 2007, it was No. 1 in its Lipper category (Mixed Asset Target Allocation Moderate) and it was No. 3 in 2010.

Barrato says it’s more difficult to provide peer ranking data for the firm’s alternative investment offerings, as they do not fit squarely into any one category. However, both the Arrow Managed Futures Trend Fund (MFTFX) and the Arrow Commodity Strategy Fund (CSFFX) have “performed well relative to other managed futures mutual funds and commodities mutual funds.”

“We are very boutique in nature and take an advisor-centric approach to delivering alternative investment and tactical portfolio solutions,” Barrato says. “We’ve acclimated with advisors that are building hedging strategies within client portfolios with the instruments Rydex was famous for, particularly leverage and inverse strategies.”

Barrato continued the focus at the new firm and is constantly “talking to the marketplace” about the need to be tactical and have alternative exposures.

“You still have a very small allocation in mainstream America to tactical and alternative investments,” he says. “There’s still a long way to go. We see ourselves as a small niche. We’re undiscovered because it’s taken us a while to get to all the right places with the client base we have.”

Barrato has signed a number of agreements with large broker-dealers this year, which has significantly increased the firm’s assets under management, but the problem with getting the “tactical” word out might be the subject matter. After all, alternative investments aren’t trending well with clients after the economic collapse in 2008—mainly because supposedly noncorrelated assets tanked with so many other asset classes. So how does Barrato get past the stigma?

“In 2008, there were a lot of alternative strategies that let people down,” he acknowledges. “In general, the way you have to articulate alternatives in a portfolio is that they are not a solution that’s going to work in every market environment. It’s a piece of the overall portfolio. If you only look at it in a vacuum and not with everything else you’re doing, then that’s your first mistake as the investor. We try to build things that are complementary. I don’t want to build the entire portfolio for an investment advisor. Advisors want to be able to pick and choose different components to add value to their clients’ overall portfolio.”

When asked about competition in the space, he has a ready, yet surprising, answer that seems to fit with his overall theme.

“You know what? I have no competitors,” he confidently states. “What we’re trying to do is get mainstream America to go from that 5% alternative allocation to a 20% allocation. If you believe in your product and put a good one in place, everything will eventually come to you if you’ve positioned it effectively and educated investors properly. That’s the most important thing from our perspective.”

Arrow Funds is a quantitative shop, and they have a partnership to acquire their technical research from Dorsey Wright & Associates. However, their investment philosophy and methodology were defined internally by their chief investment officer.

Being that it’s a complicated sector of the industry with a low adoption rate, does the firm cater to more sophisticated investors?

“We have 19,000 shareholders among our five funds,” Barrato answers. “We are catering to investment advisors that are doing their part to express the niche play that we’re giving their client portfolio. A lot of advisors are, in their own right, smart enough to be using alternatives, and that’s a good thing for us. But I would say we have an uphill battle in educating the masses.”

The Balanced Fund, the firm’s flagship, is at its five-year anniversary and, according to Barrato, has a unique way of getting exposure to multiple market strategies with a tactical overlay using exchange-traded funds.

“It has the ability to put more alternatives in the portfolio,” he explains. “It always has the traditional fixed-income components, but because of that it has lower volatility when combined with alternative exposures.”

The firm’s commodity strategy fund, launched at the beginning of 2011, “is slowly but surely getting mainstream acceptance because it’s a unique indexed approach. The index that we benchmark to has consistently outperformed all commodity indexes over the last 10-, five- and three-year periods.”

So the performance numbers are there, and the assets are beginning to follow. For Barrato, then, the focus is on education for the near future.

“We go out of our way to educate,” he says. “If you go to our website and click on the investment research or educational tabs, we go out of our way to educate on futures, commodities, alternative assets and endowments. We even created a piece called ‘Investor Behavior’ that just talks about why investors make mistakes. It’s all about market patterns. They’re not product specific and anybody can use them. Any fund company could use them because education is the most important thing.”