In my career analyzing investment products, I have found that complexity is the enemy of the investor—and the friend of the fee collector. Nowhere is this truer than in the realm of alternative investment mutual funds. These funds promise access to sophisticated strategies once reserved for institutions and the ultra-wealthy: long-short equity, market neutral, managed futures, and more. However, this access comes at a steep price, one that is often obscured by layers of jargon and complexity. Today, I will dissect the average expense ratios of these funds, explain why they are so high, and provide a clear-eyed analysis of whether the potential benefits justify their profound cost.
Table of Contents
Defining the “Alternative” Universe
First, we must define our terms. “Alternative” mutual funds (often called “liquid alts”) are registered ’40 Act funds that employ strategies beyond traditional long-only stock and bond investing. Their goal is often to provide diversification and reduce overall portfolio risk through low correlation to traditional markets.
Common categories include:
- Long/Short Equity: Funds that take both long and short positions in stocks.
- Market Neutral: Funds that seek to profit from the spread between long and short positions while minimizing market exposure.
- Managed Futures: Funds that trade futures contracts on commodities, currencies, and financial instruments.
- Multi-Strategy: Funds that combine several alternative approaches.
- Options-Based: Funds that use options for income or hedging.
The Landscape of “Average” Costs: A Premium for Complexity
The expense ratios for alternative mutual funds are significantly higher than those for traditional equity or bond funds. There is no single “average,” but rather a range dictated by the strategy’s complexity.
Table 1: Typical Expense Ratio Range for Alternative Mutual Funds
| Fund Strategy | Typical Gross Expense Ratio | Typical Net Expense Ratio* | Key Cost Drivers |
|---|---|---|---|
| Long/Short Equity | 1.50% – 2.50% | 1.25% – 2.00% | Research on both long/short sides, high trading costs. |
| Market Neutral | 1.75% – 2.75% | 1.50% – 2.25% | Complex hedging, high portfolio turnover. |
| Managed Futures | 1.75% – 3.00%+ | 1.50% – 2.50% | Proprietary trading systems, futures commissions. |
| Multi-Strategy | 2.00% – 3.25%+ | 1.75% – 2.75% | Overhead of multiple strategies, “fund of funds” fees. |
| Options-Based | 1.25% – 2.00% | 1.00% – 1.75% | Options premiums, strategy execution. |
*Net Expense Ratio: Many alt funds waive a portion of their fees temporarily to make the fund more appealing. This “net” ratio is what investors actually pay for a period, but it can rise later. The “gross” ratio is the fund’s full, unstipulated cost.
The “Average”: A reasonable estimate for the average net expense ratio across the liquid alts universe is 1.75% to 2.25%. This is 3-4 times the cost of the average active traditional mutual fund.
Deconstructing the High Costs: Why So Expensive?
The elevated fees are not arbitrary; they stem from the real and complex operational demands of these strategies.
- Talent and Research: Portfolio managers who can successfully execute these strategies command high salaries. Furthermore, analyzing both long and short ideas requires a larger, more specialized research team than a traditional long-only fund.
- Trading Costs and Infrastructure: These strategies often involve high portfolio turnover, trading in derivatives (futures, options), and short selling. These activities generate substantial brokerage commissions, borrowing costs for shorted securities, and bid-ask spreads. While these trading costs are not included in the expense ratio, they are a direct drag on the fund’s performance, making the total cost of ownership even higher.
- Risk Management and Technology: Running a market-neutral or managed futures strategy requires sophisticated risk management systems and powerful technological infrastructure, all of which are expensive to develop and maintain.
- The “2 and 20” Heritage: Many alt mutual funds are offered by firms that also run hedge funds. They bring a hedge fund pricing mindset to the mutual fund structure, aiming to capture similar fee levels.
The Performance Hurdle: A Nearly Insurmountable Barrier
The expense ratio is not just a cost; it is a performance hurdle. For an alt fund to be worthwhile, it must generate enough excess return to overcome this huge cost drag and provide a sufficient risk-adjusted benefit to justify its complexity.
Let’s assume a traditional 60/40 stock/bond portfolio has an expected return of 7%.
For an alt fund with a 2.0% expense ratio to be attractive, it must achieve one of two things:
- Higher Return: Generate a gross return high enough to net a higher return than the traditional portfolio.
- Lower Risk: Provide significant diversification benefits that lower the overall portfolio’s volatility, justifying a lower net return.
The math for the first option is daunting. The alt fund must generate a gross return of 9.0% just to net 7.0% after its 2.0% fee. That means it must outperform a simple 60/40 portfolio by 2.0% gross of fees just to break even on return.
\text{Required Gross Return} = \text{Desired Net Return} + \text{Expense Ratio} = 7.0\% + 2.0\% = 9.0\%This is a monumental task, and most alternative funds have failed to clear this hurdle consistently.
A 10-Year Cost Projection: The Weight of Fees
The impact of a 2%+ expense ratio is catastrophic over time. Let’s compare an alt fund to a low-cost traditional portfolio.
Assume a \text{\$100,000} investment over 10 years. Both strategies earn an identical gross return of 7% annually.
- Portfolio A: Low-Cost 60/40 Fund (ER = 0.15%)
- Portfolio B: Alternative Mutual Fund (ER = 2.00%)
Portfolio A Net Return: 7.00\% - 0.15\% = 6.85\%
Portfolio B Net Return: 7.00\% - 2.00\% = 5.00\%
Portfolio A Future Value:
\text{FV}_A = \$100,000 \times (1.0685)^{10} = \$100,000 \times 1.938 \approx \$193,800Portfolio B Future Value:
\text{FV}_B = \$100,000 \times (1.05)^{10} = \$100,000 \times 1.629 \approx \$162,900The Cost of the Alt Fund Fee:
\$193,800 - \$162,900 = \$30,900The alt fund cost the investor $30,900 over a decade, despite identical gross performance. This is the devastating power of a high expense ratio.
My Final Counsel: Skepticism is Your Best Asset
Alternative strategies can play a role in a portfolio, but they must be approached with extreme caution and a healthy dose of skepticism.
- Demand Justification: Before investing, ask: “What specific, persistent market inefficiency does this fund exploit, and how does its after-fee net return improve my portfolio’s risk-adjusted profile?” If the answer is vague, walk away.
- Look for Low-Cost Implementations: If you want alternative exposure, first consider simpler, cheaper methods like adding a small allocation to long-term Treasury bonds or managed futures ETFs, which can offer diversification at a fraction of the cost (e.g., 0.50-0.75%).
- Scrutinize the Net Performance: Always look at long-term net performance compared to a relevant benchmark. Do not be swayed by backtested models or short-term gross returns.
- Understand the Role: Allocate only a small portion of your portfolio (e.g., 5-10%) to these strategies, if at all. They are meant to be diversifiers, not core holdings.
The average expense ratio on an alternative investment mutual fund is a tremendous burden. In most cases, the complexity and cost overwhelm the potential benefit. The most reliable path to wealth is not through expensive, opaque strategies, but through the boring discipline of low-cost, transparent investing. By refusing to pay for complexity, you ensure that your money is working for you, not for the fund company.
