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FINRA: 6 Factors to Consider Before Investing in Alternative Funds

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The Financial Industry Regulatory Authority is warning investors about the risks of  treating alternative mutual funds like traditional mutual funds, citing “alt” mutual funds’ more nontraditional investment holdings and more complex trading strategies.

In an investor alert released Tuesday, FINRA noted that alt mutual funds, which are publicly offered, SEC-registered funds regulated under the Investment Company Act of 1940, use investment strategies that differ from the buy-and-hold strategy typical in the mutual fund industry. For instance, alt funds might invest in assets such as global real estate, commodities, leveraged loans, startup companies and unlisted securities that offer exposure beyond traditional stocks, bonds and cash.

These alt funds also may employ complex strategies, including hedging and leveraging through derivatives and short selling, FINRA notes. Some alt funds are also structured as a fund containing numerous alternative funds.

Gerri Walsh, FINRA’s senior vice president for Investor Education, noted in releasing the alert that “Investors should fully understand the strategies and risks of any alternative mutual fund they are considering. FINRA is warning investors to carefully consider not only how an alt fund works, but how it might fit into their overall portfolio before investing.”

FINRA also warns investors not to confuse alt funds with hedge funds.

Alternative mutual funds are regulated under the Investment Company Act of 1940, which limits their operations in ways that do not apply to unregistered hedge funds, FINRA states. For instance, alt funds have limits on illiquid investments; limits on leveraging; diversification requirements, including limits on how much may be invested in any one issuer; and daily pricing and redeemability of fund shares.

FINRA says investors should fully understand the following six characteristics about alt funds before they invest.

  1. Investment Structure:
    An alternative fund of funds may offer greater diversification than a single-strategy or even multi-strategy alt fund. At the same time, this greater diversification may lead to a flattening of return and potentially less transparency.
  2. Strategy Risk Factors:
    In addition to the usual market- and investment-specific risks mutual funds have, alt funds carry risks from the strategies they use.
  3. Investment Objectives:
    One fund might be designed to capitalize on management expertise in a specific area (e.g. investing in distressed companies), while another might seek exposure to commodities, currencies and other alternative investments.
  4. Operating Expenses:
    Alternative mutual funds can be pricey relative to their traditional managed fund peers; the average annual operating expense is around 1.5% per year.
  5. Fund Manager:
    Learn as much as you can about the fund manager, such as how long he or she has managed the fund. Research the professional background of a fund manager using FINRA BrokerCheck.
  6. Performance History:
    Many alternative funds have limited performance histories. For example, a fair number were launched after 2008, so it is not known how they might perform in a down market.

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