The Pros & Cons of Alternative Mutual Funds

"They lost a ton of money last year, and their risk-adjusted returns are negative over the three- and five-year periods. That's particularly troubling for investors, because I think of all the strategies, that one has the most true diversification potential," the analyst said. "Its correlation is very, very low [with equities. But it's certainly not going to be adding any value if the performance is negative."

Despite the weak performance, though, Table 2 shows that managed futures and five of the other alternative categories still managed to attract investor funds through Nov. 30, 2012.

TABLE II

(Source: Morningstar)

Horejs recommends investors use caution when it comes to relying on a fund category's average return, because the underlying funds' performances can vary widely.

For instance, she says, some funds in the long/short equity category have very long exposure to the market, while others are closer to a market-neutral position. Among multi-alternative funds, some try to replicate hedge fund or other indexes, while other funds pursue a "go anywhere" strategy.

The long/short equity category has 72 funds that were tracked throughout 2012.

Horejs says the category's top-performing fund for last year was Royce Opportunity Select (ROSFX). While that fund returned 35 percent, the lowest-returning long/short fund lost nearly 17 percent over the same period.

Most of the category's top performers had very high equity exposure for the year, says Horejs. More conservative funds with less equity exposure are "really struggling in environments like last year's," she added.

Another potential problem: Many of the funds have short performance records. Almost 60% of the alternative-strategy funds Morningstar tracks launched after 2008.

To help investors and advisors identify the funds that are most likely to achieve their advertised diversification and risk-reward profiles, Morningstar recently started recognizing the top performing funds. More information on the award nominees in the alternatives category is available at Morningstar's website.