Hey, SEC, A Modest Proposal: Ban 'Alternative' Investments

Photographer: Jeff Kravitz/FilmMagic via Getty Images

Kurt Cobain of Nirvana during MTV Live and Loud: Nirvana Performs Live in this Dec. 1993 file photo in Seattle, Washington. Close

Kurt Cobain of Nirvana during MTV Live and Loud: Nirvana Performs Live in this Dec.... Read More

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Photographer: Jeff Kravitz/FilmMagic via Getty Images

Kurt Cobain of Nirvana during MTV Live and Loud: Nirvana Performs Live in this Dec. 1993 file photo in Seattle, Washington.

When Kurt Cobain was in his prime, there was little doubt what alternative music was. It wasn't just "an alternative to traditional rock music" -- that could have included everything from R&B to polka -- but a distinctive genre with Pacific Northwest roots and a punk sensibility.

Twenty years after Cobain's death, Wall Street is in the midst of its own alternative craze, and almost any asset can be called alternative, as long as it’s not a traditional stock or bond.

Amid a frenzy of new products launches and marketing, apartment building owners, pipeline operators, farmland and high-frequency traders all get the label. And in just two years, the share of U.S. mutual fund assets in alternatives is expected to double to 6 percent, from 3 percent, according to research firm Cerulli Associates. Almost half of the mutual funds called “alternative” by Bloomberg have launched since 2011, and Boston Consulting Group estimates alternative assets have risen from $2 trillion to $7 trillion in the last decade. That growth has the attention of the Securities and Exchange Commission, which is examining alternative mutual funds.

Regulators have asked big alternative asset managers including BlackRock Inc. and AQR Capital Management for information, the Wall Street Journal reported Aug. 12. Bloomberg News reported in April that the SEC’s concerns include how boards are overseeing the funds and how much risk funds are taking. A suggestion for the SEC: Look closely at mutual fund marketing material, then ban all use of the term "alternative." It’s meaningless. People seeking to diversify their portfolios or protect themselves from losses can end up in highly leveraged funds better suited for professional traders. It's as if a '90s record store put Nirvana CDs in the 'alternative' bin along with albums from Boyz II Men, Garth Brooks and Philip Glass. And in investing, sloppy categories lead to confusion and bad decisions -- far worse consequences than a discordant playlist.

Alternatives owe their popularity not just to clever marketing but to academic theories about investing risk. By diversifying a portfolio, the theory goes, the right alternative to stocks and bonds can lower the risk in a portfolio. Exposure to alternatives is generally kept to 10 percent or less.

That theory only works if investors choose wisely among a bewildering array of options, many new and relatively unproven. Easy to understand are so-called "real assets" in the alternatives world -- real estate, agriculture, timberland and commodities. They can protect against inflation, says University of Illinois Professor Jeffrey Brown, though he warns too much exposure can be dangerous. Real assets can also crash during recessions and economic crises.

Other alternatives are hard for even experts to understand. There are merger arbitrage funds, momentum funds and long-short funds. These complex strategies, borrowed from hedge funds, are often designed to hold value even when stock or bond markets are in free fall. Of course, no one can say for sure they'll work during the next crisis.

Most investors can ignore the vast bulk of alternative assets. The high fees on most of the products are a bigger threat than the possibility investors might not have an ideal investment allocation, argues Brookings Institutions fellow Ben Harris.

There’s a great quote from famed value investor Benjamin Graham that all of this brings to mind: “While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster.” That might be a little strong. But creativity on Wall Street is often costly for investors.

More stories by Ben Steverman:

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