Investors piled into alternative mutual funds, especially those that mimic long/short hedge funds, at a record pace last year, as tracked by Morningstar.

For 2010, the alternative categories had $18.8 billion in net inflows — nearly 50 percent more than the $12.7 billion net inflow for 2009. For 2007 and 2008, net inflows were $2.8 billion and $4.6 billion, respectively.

Managers from both the hedge fund and mutual fund side of the aisle are jumping into the business. But despite the trend, the relative size of the alternatives mutual fund space is tiny compared to the other mutual fund categories, and financial advisors are advising caution with the relatively young investment category.

Morningstar tracks 420 funds in its alternative categories, including 182 mutual funds and 238 exchange-traded funds. Most of what would be considered actively managed hedge-fund type strategies fall into the long/short and market neutral categories, with most of the currency and bear-market funds following index strategies, said Nadia Papagiannis, alternative investments strategist at Morningstar.

Long/short funds tracked by Morningstar have $39.7 billion under management, a far cry from the largest general categories of mutual funds: large blend funds, with $1.028 trillion, and intermediate-term bond funds, at $823.5 billion.

The Lessons of 2008

Investors seem to be attracted to alternative mutual funds as a way to manage downside risk for their portfolios, especially after a more traditional method — diversification — failed during the 2008 market meltdown, Papagiannis said.

Before 2008, many investors believed they would be safe if they split up their portfolios across equity and bond categories, and by geography, she said — a little in large-cap equities, a little in small-caps, and in different categories of bonds, and in Europe, and Asia, and emerging markets, for example.

“That turned out not to be a good way to diversify,” Papagiannis said. “In times of crisis, they all acted the same. The less-liquid stock classes, emerging-market type stocks — they crashed even harder.”

“The point is, in a liquidity crisis, the only thing that's going to hold up is U.S. Treasuries and some of these alternative funds,” Papagiannis said. Treasuries, of course, are not going to provide returns needed by most investors over the long term, and they are susceptible to inflation and rising interest rate risks.

Market volatility over the past several years has driven investor demand for asset classes with good track records in both up and down markets, said Michael Sheldon, chief market strategist for RDM Financial, a registered investment advisor with $600 million in fee-based accounts.

Many mutual funds that attempt to replicate long/short equity hedge fund strategies have such short track records that investors are still hesitant to commit, Sheldon said.

RDM clients with exposure to alternative strategies typically have 3 percent to 4 percent of their equity portfolio invested in the sector. “You never want to take big bets,” Sheldon said.

For hedge funds themselves, after the Bernie Madoff scandal and the number of managers who blocked the exits for investor redemptions in 2008, and the high fees, investors are “a little bit gun-shy,” he said.

A problem with a lot of the long/short mutual funds is failure to make money on the upward market swings, Sheldon said. “Our job is both to grow assets and to protect assets.”

Average returns tracked by Morningstar prove that point: Long/short mutual funds did do a better job at protecting on the downside, relatively, in 2008, posting a return of negative 15.4 percent versus negative 41.9 percent for the world of stock mutual funds.

But in every other year since 2005, including 2010, the two categories have had positive returns and world stock mutual funds performed better. Last year, long/short mutual funds posted a 4.1 percent average return, compared to 13.7 percent for world stock funds. Measured by risk-adjusted returns, by Sortino ratio, long/short funds have also underperformed.

Laila Pence, president of Pence Wealth Management in Palm Beach, Fla., said she's seen demand among her clients for hedge fund strategies dwindle to a trickle, especially after poor performance for those strategies last year relative to the markets. Pence Wealth manages about $600 million, mostly on behalf of retirees and so-called pre-retirees, including those who meet net worth requirements for investing in regular hedge funds.

Hedge funds have several strikes against them, she said, “especially when you add the cost to [underperformance] and the complexity, and then you add Madoff on to it.”

Dryden Pence, her husband and chief investment officer of the firm, said that many clients are just beginning to move back into the markets, and putting trust in their advisors. For those just dipping their toe in, simplicity equals trust, he said. Hedge funds that manage complex strategies and operate with a lack of transparency aren't going to win that kind of trust from the individual investor.

“I think they [hedge fund managers] are still riding their same pony, and it's a different race. The racetrack is different now,” he said.

“There are plenty of other opportunities that are simple, liquid and clear,” he said, including many opportunities with high-dividend-paying stocks and high-yield bonds from stable companies.

Hedge funds may regain a foothold with individual investors if the market changes, Dryden Pence said. “They may come back into vogue if they show a clear, meaningful trend that they can capitalize on,” he said.

Hedgies Going Retail

On the supply side, it is mostly hedge fund shops that are driving the growth in alternative mutual funds, Papagiannis said, though mutual fund managers — mostly boutique shops — are also launching offerings in the category.

The hedge fund industry as a whole has had difficulty raising capital since the 2008 credit crunch, so some managers have started mutual funds as a way to diversify their business lines and to find new investors in the retail market, she said.

AQR Capital Management in Greenwich, Conn., is the largest hedge fund manager in the mutual fund space, with $29.5 billion overall and $2.5 billion in eight mutual funds. AQR launched its first mutual fund in January 2009, but it started planning two years before the 2008 market meltdown, when it hired a president of mutual funds, said David Kabiller, a co-founder of AQR.

For AQR, Kabiller said, getting into the space made sense because he and the other principals had managed mutual funds, long-only strategies and hedge fund strategies going back 20 years ago to their days at Goldman Sachs (they left to start AQR in 1998). AQR started its first long-only fund, for institutional investors, in 2000.

A lot of hedge fund equity and managed futures strategies fit easily into the Investment Advisers Act of 1940 mutual fund structure, Papagiannis said. Other hedge fund strategies will never fit the format, such as fixed-income arbitrage or distressed, because they are too illiquid or too leveraged.

Whether other hedge fund managers are willing to get into the mutual fund business probably depends on whether they are willing to build the very expensive compliance infrastructure necessary and have the sensitivity to deal with the increased regulatory oversight, Kabiller said.

Hedge fund managers face several constraints when adopting a hedge fund strategy for a 1940 Act mutual fund, said George Mazin, a partner at Dechert law firm in New York. The chief restrictions are daily liquidity requirements, significant limitations on leverage, a limited ability to sell short and the requirement to operate with an independent board of directors.

While operating a hedge fund without the mutual fund structure frees the manager from restraints on leverage, shorting and liquidity, the manager then faces limits on who is allowed to invest in the fund.

Generally, Mazin said, for a type of hedge fund restricted to 99 investors, an individual must meet one of four criteria that include either a minimum net worth of $1.5 million or annual income of $200,000. For a second type of hedge fund, for up to 499 investors, the wealth requirements are steeper, including that the individual have at least $5 million in securities investments, not including homes and closely held businesses.

Managers starting a hedge fund-like vehicle also must adapt, Papagiannis said — adding a trader and risk manager, and using a prime broker for short selling, for example.

If a hedge fund manager has just one mutual fund in mind, the overhead costs are probably too great to justify the business, Kabiller said. Also, the hedge fund manager receives lower fees in the mutual fund model. And once a mutual fund company has been established, it takes 75 to 120 days to get a proposed fund through the SEC's regulatory hurdles, he said.

A higher degree of investor education is also necessary with mutual funds, which is one of the reasons why AQR planned to stop allowing retail investors directly into its funds at the end of October, Kabiller said. Instead, the funds are distributed through financial advisors only.

There is a “high-touch” sales approach needed with the strategies that AQR runs through its mutual funds, Kabiller said, and financial advisors provide that, adding a sophisticated view of what the AQR funds can provide for efficient, non-correlated returns.

“Every financial advisor wants their clients' portfolios to zig and zag differently (than the market) to improve returns,” he said. “If people understand what we're doing, then if we go through tough times, they not only stay with us, but they may add to their position.”

Boston-based mutual fund manager Eaton Vance Management rolled out a new hedge fund-like vehicle, Eaton Vance Option Absolute Return Strategy Fund, in October. It manages about four groups of funds considered described as having hedge-fund-like strategies.

Walter Row, head of the options strategy funds, said Eaton Vance started those funds as a response to demand from investors for funds with high levels of distributed income. With equity and equity index options strategies, a fund manager can create income from market volatility, Row said.

“In our funds, we're not looking to push the envelope,” he said.