FINRA Warns Investors On Alternate Funds

by Trefis Team
State Street
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Last week the Financial Industry Regulatory Authority (FINRA) released a cautionary note aimed at educating investors about the risks involved in the increasingly popular alternate mutual fund offerings. [1] The note emphasized on the fact that alternate (or ‘alt’) funds use complex trading strategies and extend one’s exposure well beyond debt and equity, because of which retail investors should be very clear about the risks involved before they put their money in these rapidly growing investment options.

The warning in itself is not totally unexpected considering that the prolonged low-interest rate environment has tempted institutional and retail investors alike to explore alternative investment options that promise higher returns – a situation that has led to the alt fund market swelling in size, nearly six-fold from just over $30 billion in 2008 to almost $180 billion this May. [2] And with the world’s biggest brokerages Bank of America-Merrill Lynch (NYSE:BAC) and Morgan Stanley (NYSE:MS) as well as asset management giants BlackRock (NYSE:BLK) and State Street (NYSE:STT) unveiling plans to make more money from the growing alternative fund industry in the recent past, unrestricted growth in the area could easily see this warning ending with tighter regulations down the line.

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While there is no doubt that the condition of the global debt and equity markets has improved considerably since the economic downturn of 2008, investment options have shrunk considerably due to stagnant interest rates in the U.S. and the continuing slowdown in Europe. The situation has spurned demand for high-yield investment options among investors – something the world’s largest financial institutions have only been too happy to fulfill.

But the fact that investors seem to be turning a blind eye to is that the high returns come with higher risks. Alternative investment funds are one such class of investments that have attracted the attention of investors over the recent months without really raising many questions in their minds about the risks attached. As FINRA explains in its cautionary note, these funds hold “more non-traditional investments” like real estate, commodities, leveraged loans as well as unlisted securities, and also make use of  “more complex trading strategies” which include the use of derivatives and short-selling to boost profits. Investors are hence well-advised to keep their risk-profiles in mind as well as their overall portfolio goals before opting for these risky investments.

The warning will definitely force investors to put in more thought before they decide to pursue alt fund options, which in turn could reduce the pace of asset growth for these funds. Moreover, the financial watchdog would definitely want to avoid a situation similar to what was seen in 2008 when retail investors were drawn to high-risk investments on which they ended up incurring stinging losses and spurned scores of lawsuits against the financial institutions. This may lead to regulations being imposed on such funds in the future, putting further downward pressure on their growth.

One can understand the impact of slower growth in total assets under management on Bank of America’s share value by making changes to the chart below.

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  1. Alternative Funds Are Not Your Typical Mutual Funds, FINRA Website, Jun 11 2013 []
  2. FINRA warns investors on alternative mutual funds, Reuters, Jun 11 2013 []
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