As the dust settled two years ago at the end of the most recent bear market, many investors were forced to pick up the pieces of their investment portfolio and retirement accounts. Most equity mutual funds ended the period down more than 40%, and it seemed as though the investment landscape would never be the same. This downturn broke all the rules about padding one's portfolio with proper asset allocation. The problem was that as the global markets crashed, the correlation between opposing asset classes began to increase.

As money began to come back into the market, investors and advisors thought differently about portfolio creation and diversification. Both a higher level of risk aversion and the case for better risk diversification had been made, with the impact seen in allocations and products. On the core side, exchange-traded products began to proliferate and garner large amounts of assets. But demand for actively managed funds also continued.

The more common non-traditional approaches in mutual funds are long/short, equity market-neutral, global and domestic tactical allocation, managed futures and unconstrained bonds. When added to an investment portfolio, these products may create opportunities for return enhancement or risk reduction. Often, this is due to the strategies' flexibility, and it relies on the manager's ability to act on market trends. The bear market created a chance for their proliferation as investors and advisors sought solutions to volatility.

Lipper classifies these strategies in the groups: absolute return, equity market-neutral, long/short equity, flexible, global flexible, extended large-cap core (130/30), and multi-sector income. At the start of 2007, we saw a steady increase in the creation and marketing of products within these groups. As a percentage of all mutual fund launches, exclusive of money market funds, these products have grown from roughly 10% of the new offerings during 2007 to 21% for 2010 and about 24% this year. And as the number of funds continues to increase, so has investor demand.

Looking at the estimated flows for the products, we saw a rise after the lull of 2008, with roughly $50 billion in net inflows for 2009 and $87 billion for 2010. The trend has continued into the current year. We have already seen $53.7 billion in new money as of May 31 and the combined assets for these groups amount to roughly $480 billion, compared to $229 billion at the end of 2007.

This growth in non-traditional offerings might be due to demand by the investor channel and a decision by the fund companies themselves. Since the crash in 2008, the mutual fund industry has consolidated considerably. This has allowed for the creation of new products that can challenge and complement other core offerings. Those companies that are not as internally diverse seek to compete with the help of a subadvisor, a specialist in certain investment sleeves of the new strategies. Another motivation may be the ever-expanding exchange-traded funds (ETF) market. The advantage of these strategies is that they cannot be easily replicated as ETFs and avoid the pressures facing others.

You should know that these products' unique qualities can yield higher costs. Based on the range of total expense ratios, investors can expect to spend between 475 basis points (bps) and 10 bps. The average net prospectus expense ratio for the group analyzed is approximately 185 bps.

The continued growth prospects for these funds may depend on their performance in future cycles. Since many are designed and advertised as solutions to mitigate losses in downturns, they will face two challenges: If the markets continue their bull run, will these products be able to keep pace? If not, they could go the way of principal protection products, since investors who feel the flexibility and possible downside hedge may no longer be worth the gains they are seeing with long-only products?

The other challenge is that in another sustained bear market, will they deliver the downside protection and market nimbleness promised? This pressure could be even greater for those products that claim to provide absolute (positive) returns. Remember that the non-traditional strategies that were active during the last bear market posted average losses of roughly 30% and that any new products created since then have yet to be tested.

Matthew Lemieux is a research analyst for Lipper,
where he specializes in performance analysis,
methodology management and fund flows.
He is a regular contributor to the Lipper FundFlows Insight
reports and the weekly video series.

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