These funds make it easier than ever to smooth out your returns with investments that swim against the tide. Patrick George By Carolyn Bigda, Contributing Writer From Kiplinger's Personal Finance, September 2014 Alternative investment strategies used to be synonymous with hedge funds and the endowments and wealthy investors that bought into them. But now a growing number of mutual funds are adopting hedge-fund tactics, from betting on stocks that could decline (known as shorting) to buying futures contracts to ride market trends. Alternative mutual funds are cheaper to own than hedge funds, they’re more transparent about what they own, and you can sell them on a daily basis.See Also: You Name It, They Trade It They could also add value to a portfolio. Robert W. Baird, an investment firm, calculated that for the 20 years through the end of September 2013, a traditional portfolio with 60% in Standard & Poor’s 500-stock index and 40% in Barclays U.S. Aggregate Bond index returned an annualized 7.9%. But a portfolio with 50% in stocks, 30% in bonds and 20% in indexes that included hedge funds and other alternative strategies returned 8.2% annualized, with fewer ups and downs. Explosive growth. Investors still shell-shocked by the 2007–09 stock market catastrophe and anxious to check future losses in both stocks and bonds are taking notice. From the end of 2007 through the end of 2013, assets in alternative mutual funds and exchange-traded funds more than tripled, to $184 billion, according to Morningstar. Advertisement But adding alternatives to your portfolio is not without risks. For one, many alternative funds are relatively young, meaning they don’t have much of a record to go on. What’s more, their results can look sickly when the stock market is on a roll. Over the past five years, the average alternative fund gained just 2.9% annualized, compared with 18.8% for the S&P 500 (returns are through June 30). Finally, fees are high; the average annual expense ratio for alternative mutual funds is 1.9%. That’s well above the average 1.2% annual charge for a diversified domestic stock fund—though the mutual funds are cheaper than hedge funds, which can charge as much as 2% a year and claim 20% of profits. If you’re considering an alternative fund, stick with those that have proven leadership. Also, be sure of what you’re getting. “There can be a lot of variability” in these funds’ strategies, risks and return potential, says Laura Thurow, director of private wealth management research at Baird. Below are five no-load funds with solid records (by the standards of this category) and reasonable fees. Judging from its stable returns, you’d never guess that Merger Fund (symbol MERFX) owns stocks. But the 25-year-old fund does just that. Merger, a member of the Kiplinger 25, invests in stocks of already announced takeover and merger targets, hoping to capture the last bit of appreciation before a deal is finalized. Recently, the fund’s returns have paled next to the torrid run of U.S. stocks. Merger earned just 3.8% annualized over the past five years, trailing the S&P 500 by a huge amount. But during broad market downturns, the fund has excelled. It lost just 2.3% in 2008, when the S&P plunged 37%. The fund has been about 75% less volatile than the overall stock market over the past ten years. The fund’s performance is likely to improve if interest rates rise. A well-executed merger-arbitrage strategy typically earns three to five percentage points per year more than the yield of Treasury bills (currently about 0%), says Merger co-manager Mike Shannon. Higher short-term rates, which could come next year, should lead to higher returns for Merger investors. The fund charges reasonable fees of 1.26% annually. Advertisement Wasatch Long/Short Fund (FMLSX) takes more risks. The fund usually starts with a stock position that’s 80% long (a bet that the stocks will rise in value) and 20% short, and it can adjust from there. At last report, the fund was 83% long and 10% short, meaning it was essentially 73% invested in stocks. Long/Short won’t capture all the gains of a bull market, but it probably won’t stumble as much during selloffs. In 2008, the fund dropped 20.9%. The fund’s annual expense ratio is 1.28%. Michael Shinnick and Ralph Shive have been at the helm since Long/Short’s 2003 launch. Energy, financial and technology stocks recently made up the biggest weightings on the long side of the portfolio. Meanwhile, the managers shorted richly priced growth stocks, including Facebook and specialty coffee company Keurig Green Mountain. Long/Short tries to deliver stocklike returns with fewer bumps. If you want a stock fund that will move more independently of the broad market, check out TFS Market Neutral (TFSMX). The decade-old fund closed to new investors in 2009, but it reopened earlier this year. TFS, which invests primarily in the stocks of small and midsize companies, maintains its “market neutral” stance by generally holding an equal ratio of long and short positions. In selecting stocks, the six managers use computers to screen for such things as valuation, earnings surprises and stock-buyback activity. Among TFS’s long positions at last report was Pioneer Energy Services, which has regularly exceeded quarterly earnings forecasts over the past year. The fund has shorted Galena Biopharma, which has generated inconsistent results. TFS is a classic example of an alternative fund that dances to its own tune. Last year, it returned just 1.4%, trailing the S&P 500 by a staggering 31 percentage points. But in 2008, it lost just 7.3%. Annual fees are 1.81%, about average for the category. Advertisement Pimco All Asset All Authority (PAUDX) qualifies for our roster of alternative funds by investing in nontraditional investments, such as commodities and emerging-market currencies. Manager Rob Arnott, CEO of Research Affiliates, a California firm that manages $169 billion in assets, invests in 40 or so Pimco mutual funds. He may also use borrowed money, a favorite tool of hedge funds, to boost returns. All Asset All Authority’s mission—to deliver annual returns that average 6.5 percentage points more than the rate of inflation, as measured by the consumer price index—underscores its independence from the stock and bond markets. The fund had a miserable 2013, losing 5.9%. But it gained 6.1% in the first six months of 2014, and its ten-year annualized return of 6.7% trails that of the S&P 500 by only one percentage point per year, on average. In 2008, the fund surrendered 7.5%. The Class D shares are available through many online brokers without sales charges. Annual fees total 1.24%. Stock funds are not the only ones that use alternative strategies. Bond funds, including Metropolitan West Unconstrained Bond (MWCRX), have also gotten into the game. The three managers of Unconstrained Bond, a member of the Kiplinger 25, do not hew to a specific benchmark, preferring instead to look for what they believe are the best opportunities in the fixed-income universe. Today, that includes commercial mortgages and residential mortgages that aren’t backed by government agencies. The managers can also hedge against rising interest rates (bond prices and rates move in opposite directions). Lately, they’ve been doing so by selling short Treasury bond futures. The strategy has worked. Last year, when the U.S. Aggregate index fell 2% because of concerns that the Federal Reserve would scale back its easy-money policies, Unconstrained Bond gained 2.9%. The fund is only three years old, but its managers have decades of experience. Annual fees are 0.99%—higher than we’d like but worth the price for the extra protection. Advertisement Five popular strategies Bear market. Mainly sells stocks short to take advantage of declines in individual shares or in the overall stock market. Best used only to make a short-term tactical bet. Long/short. Attempts to earn positive returns regardless of market conditions by holding both long positions in stocks (a bet that values will go up) and short positions. Market neutral. Similar to a long/short strategy but holds an equal ratio of long and short positions to minimize the effect of market gyrations. Managed futures. Uses futures contracts (agreements to buy or sell assets at a set price in the future) as a way to profit from trends in stocks, bonds, commodities and currencies. Merger arbitrage. Buys shares of takeover targets after a deal is announced, in hopes of capturing the final few dollars (or cents) of appreciation once the deal is completed.