Who will be alts' best in show?

Among asset managers, the competition for best-of-breed in alternative strategies has officially begun. The demand for liquid alternatives, either in a mutual fund or exchange-traded-fund package, has never been higher, and it is drawing in a pack of money managers who are all vying to be top dog. Despite this year's epic stock market performance, worries over rising interest rates and how long the rally can last have led to alternatives — which are considered a way to hedge against stock or bond market risk — selling at the fastest pace ever. Alternatives mutual funds this year had $68 billion in inflows through the end of August, 50% more than the funds received in any full year since the financial crisis, according to Morningstar Inc. “It's blowing up,” said Nadia Papagiannis, an alternatives fund analyst at Morningstar. And where there is money pouring into a strategy, there is sure to be a race among money managers to chase after the spoils. Everyone from the biggest money managers, such as BlackRock Inc. or The Goldman Sachs Group Inc., to traditional hedge fund companies, such as AQR Capital Management LLC, and even old-school mutual fund shops such as Janus Capital Group Inc. and Putnam Investments, have been flooding the market with enough new products to make financial advisers' heads spin. In the past two years, more than 150 alternatives mutual funds have been launched, up from a little more than 100 between 2008 and 2010, and just a handful pre-financial-crisis. “Companies have their marketing hats on,” said Melissa Joy, director of investments at the Center for Financial Planning Inc. The bigger companies are launching a variety of strategies, such as multi-alternatives, which seek to be one-stop shops for alternatives exposure, long/short emerging markets and risk parity, which offers a new spin on the classic 60/40 portfolio. The smaller ones, boutique firms such as 361 Capital LLC, are focusing on a specific niche, such as managed futures.

'Ton of choices'

The influx of new funds, especially in relatively new-to-mutual-fund strategies, such as long/short credit, means that advisers have their work cut out for them when it comes to picking a fund. “There's a ton of choices, but a lot of it's questionable,” Ms. Joy said. “You don't want to put your clients' money in someone's experiment.” So far, returns have been mixed. In the long/short equity category, which has the longest track record, the average fund has a three-year annualized return of 6.8%, but the top-performing $11 million Guggenheim Alpha Opportunity Fund (SAOAX) has a three-year annualized return of 28%, while the bottom-performing $1.8 billion Hussman Strategic Growth Fund (HSGFX) has a three-year annualized return of -4%. “It definitely takes a lot more time and energy to do due diligence on alternatives managers,” Ms. Papagiannis said. “The strategies are different,” she said. “They're more complicated and take a deeper understanding of portfolio construction.”

Taking notice

The good news for advisers, who essentially are the early adopters of alternatives mutual funds, is that institutions are finally starting to take notice of liquid alternatives. Institutions are notoriously pickier when it comes to choosing strategies, so the extra rigor they apply to liquid-alternatives mutual funds should force companies to step up the quality for everyone. “Institutions were waiting to see if it was a fad or the real deal. Now that liquid alternatives have been around long enough, they're looking into them,” Ms. Papagiannis said. “Institutions looking into liquid alts will make them better for everyone.” More than 45% of institutions said that they use long/short mutual funds, for example, up from 38% in 2010, according to the Morningstar and Barron's 2012 Alternative Investment Survey of U.S. Institutions and Financial Advisors. The number of institutions that are using hedge funds to access long/short strategies has plummeted to 26%, from 61% in 2010, according to the study. Even though the competition is starting to heat up, it still may be some time before it becomes clear who the winners and losers are, experts said. For example, just a handful of nontraditional bond funds, this year's most popular alternatives category, have started to hit their three-year track records. The $8 billion Goldman Sachs Strategic Income Fund (GSZAX), which ranked as the top nontraditional bond fund over the 12-month period ended Sept. 16, celebrated its third birthday June 30. “It's like any industry. You have some good funds, some not-so-good funds and a lot of funds in the middle,” said Ihor Szeremeta, director of BlackRock's U.S. wealth advisory alternatives business. “We're a ways away from starting to crown the best-of-breed,” Mr. Szeremeta said. “As every year passes, as more entrants enter the space and the bar keeps getting raised, the best will start to rise to the top.” Given the hopes that advisers are pinning on liquid alternatives, the best-of-breed companies probably can't rise soon enough. “The demand for alternatives investments will only get stronger going forward,” said Spuds Powell, managing director at Kayne Anderson Rudnick Investment Management LLC. “Most of our clients suffered a lot of pain in 2008, and many of them suffered a lot of pain in 2002,” he said. “Now there's a lot of nervousness over the risks in the world.”