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Are Alternative Funds Losing Their Luster?

Mutual funds that invest in alternative types of securities, ranging from commodities to private equity investments, have been hot. But the heat appears to be cooling off.

On the plus side: alternative mutual funds saw inflows of $23.2 billion in 2011, according to Morningstar's latest annual survey examining usage of alternative investments among institutions and financial advisors. Not counting the "nontraditional" bond category, they still took in $14.2 billion Meanwhile, U.S. equity mutual funds bled $84.7 billion.

Not so encouraging: alternative ETFs in 2011 gained just $11.6 billion, the lowest level since 2006. For that matter, inflows for alternative mutual funds were $1.8 billion less than the prior year. And some 65% of advisors and 67% of institutions indicated that alternative investments are as important or more important than traditional investments, down slightly from the last survey.

"Institutional investors and financial advisors have significantly expanded their alternative holdings since the 2008 crash, and continue to view alternative investments as an important part of their portfolios," said Scott Burns, director of ETF, closed-end fund, and alternative research for Morningstar, said.

"Growth has begun to slow, though, as investors have ramped up their allocations, and excitement may be cooling with the lackluster performance of alternatives relative to the overall market over the last few years," Burns said.

So is the hype fading from the alternative fund space?

Well, sort of. On the ETF front, Marc Odo, Director of Applied Research at Zephyr Cove, NV-based Zephyr Associates, says advisors are not just jumping into alternative ETFs feet first anymore because they're headline-grabbing products.

"ETFs and hedge funds are not magic bullets; they're different wrappers to access different strategies," he says. "They offer the possibility of diversification but when the rubber meets the road, people need to be aware of a few things" such as liquidity and transparency.

Regarding liquidity risk, Odo says just take a closer look at First Trust Global Wind Energy (FAN).

"While an advisor might think investing in 'wind energy' would be a nice, futuristic play," Odo says, according to the ETF's Website, the top ten holdings of this ETF represent over 50% of the allocation.

Moreover, the median market capitalization of the stocks in this portfolio is only around $2 billion and two of those top-ten names are Chinese companies.

"If it were me, I'd have concerns about how liquid the underlying investments are," he says.

Also, another risk to advisors is transparency, which should literally be taken with a grain of salt, according to Odo. For example, he says the ELEMENTS MLCX Biofuels Index ETF is a misnomer because "with a name like 'biofuels' you might be thinking you're investing in some kind of a high-tech, wave-of-the-future green technology."

But its Website discloses that the fund is investing in futures contracts for barley, canola, corn, rapeseed, soybeans, soybean oil and sugar. "Now if you want to make a play on grain prices, that's fine, but calling this ETF 'biofuels' is a bit, oh, let's say creative," he says.

One ETF purveyor who isn't scared off by Morningstar's sobering findings is New York-based Global X Funds. The firm currently counts an auto and social media ETF as part of its alternative portfolio.

On top of that, the firm last week introduced the Global X Top Guru Holdings ETF, which gives investors exposure to hedge funds with at least $500 million in assets, and it has filed to launch two additional alternative ETFs: a value investor-based fund and an activist fund.

Global X Funds CEO Bruno del Ama says he's not concerned about ETFs' recent flows hiccup. "One of the points people indicate why they're holding back on their growth is the high cost of these strategies a well as the lack of liquidity," he says. "GURU provides some of the lowest costs out there with transparency as you can see on our Website. ''

Del Ama offers that over the past five years, the highly concentrated ETF space has experienced growth outside of the top three ETF providers (iShares, Vanguard and State Street). "In the ETF space, you can grow through innovation and low costs. You see a lot of slicing and dicing being implemented by companies including iShares and Global X, and I think passive-based simple access-type strategies are coming to an end and a lot of the growth is going to come from existing beta-type products," he says.

John Cadigan, National Sales Manager at Boston-based Direxion Funds, which offers both alternative mutual funds and ETFs, attributes the asset class' slowdown in growth to complacency. "In general, over the last two years the market's been up 20% and you get a level of complacency and people like to go back to their comfort zones," says Cadigan.