Is your ‘alternative’ mutual fund a ticking time bomb?

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An ‘alternative’ fund sounded like a good idea, but we don’t have a clue what’s in ours.

Most people who own “alternative mutual funds” can’t accurately describe what they’ve got in their portfolio.

The label “alternative” seems to cover countless strategies and, technically, can be applied to anything that falls outside of the mainstream investment categories of stocks, bonds and cash.

But the Securities and Exchange Commission clearly has some concern that what is being marketed to the public as a panacea for making money in volatile, unpredictable markets could also be a hot potato or, worse, a ticking time bomb.

Afraid that investors could see their portfolios blown up by issues they don’t fully recognize or understand, the regulatory agency recently launched a broad examination of alternative funds.

Sources close to the probe say the SEC has been doing “sweeps” at big-name firms (think BlackRock Inc. BLK,+1.12%  and AQR Capital Management), while also tapping some small firms that are new in running hedge-like mutual funds for small investors. The agency is not necessarily looking for or expecting to find wrongdoing, but more seems to want to get a handle on one of the fastest-growing parts of the fund world before the market tests the new products in ways that investors aren’t prepared for.

SEC officials have confirmed that about 30 firms will be examined; the sweeps will include contact with fund board members, trying to determine whether the complexity of these types of funds requires specialized oversight.

Alternative funds have been the hot trend in the fund world for a few years now, with inflows of more than $40 billion in 2013 and about $17 billion more this year, according to Morningstar Inc. The Chicago-based research firm pegged the amount in alternative funds at north of $260 billion last year.

But the “alternative” label means many things to many people.

Typically it describes mutual funds that use strategies traditionally reserved for hedge funds. The category started with long-short, market-neutral and absolute-return strategies, typically funds that use short-selling strategies to generate positive returns even when the market is flat or down. For all the hype, the majority of these funds have proven to be mediocre performers regardless of market conditions.

Today, a lot of the focus is on “liquid alternatives,” which typically means buying illiquid securities — things like private credits and some derivative issues — and turning them into a fund that is “liquid” because it can be bought or sold at any moment on the open market.

But “liquid” may refer to how watered-down and diluted some of the strategies are. It’s also where regulators are nervous, because some of these strategies could fall apart the next time the market experiences hurricane conditions.

“A lot of the underlying investments in these alternative funds will prove problematic in different situations,” said Jeff Sica, chief investment officer at Circle Squared Alternative Investments, a new firm that evaluates issues in the space, but which also is pursuing its own alternative solutions.

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“If the underlying assets can’t be easily liquidated, there’s a real question of what happens if the market has a problem,” Sica said. “There’s no real liquidity in alternative investments. It doesn’t exist, which is why probably 95% of liquid alternatives funds are useless. … Most are just institutions trying to get on the bandwagon, creating liquid shells; if they were real alternatives, they would not be as liquid as they are.”

Sica and other experts suggest one area of concern would be with private credit, where funds are investing in deals that a typical bond or income fund could not pursue, and suggesting that these private credit deals will deliver income streams of up to 7%.

In the event of an economic meltdown like the financial crisis of 2008, however, there’s no guarantee that the private credit obligations will be met; if panicky investors rush the exits, a fund would now be left trying to unload those private credits to meet redemptions, in a market that is illiquid.

That’s how a mutual fund implodes.

Ultimately, the likelihood of that kind of event is precisely what the SEC is trying to determine, at which point it will determine what kind of actions to take, whether that is stiffer warnings about the risks of the funds, all the way on up to ruling that some of the funds have crossed boundaries and need to be shuttered.

Meanwhile, investors should know at least that alternative funds may fall into one broad category, but they can be unique and individual, meaning it would be a mistake to assume that the risks associated with one fund are the same with the next. Conversely, if alternatives are appealing, experts suggest diversifying and using different funds to share the alternative space in a portfolio.

“Investors may not know what they’re buying, but they should know enough to split their alternative money between a few funds,” said Sica. “Hopefully, there is never a problem that makes any of these funds suffer or vanish, but you should at least invest like problems with alternative funds are possible because, well, they are.”