The Securities and Exchange Commission (SEC) has begun a thorough investigation of alternative mutual funds, a very popular yet controversial investment product for small investors.

Alternative mutual funds use hedge fund strategies, such as short selling, futures contracts and leveraged derivative products, to generate returns for their clients. Total assets have neared $320 billion, an eightfold increase in eight years, from $40 billion in 2006, according to fund tracker Lipper. At the end of 2012, the figure was $180 billion.

Capital inflows into this category grew from $14.5 billion in 2012 to $40.2 billion in 2013. Through July 2014, this figure reached $16.8 billion, according to Morningstar.

High atop the list of those being investigated are BlackRock, the largest asset manager with $4.3 trillion in assets, and AQR, an investment manager and hedge fund with $113 trillion under management. Additional prominent firms involved in this space or soon to introduce products include Goldman Sachs, Blackstone, Bank of New York Mellon and Pimco.

Vanguard, the largest mutual fund firm, has elected not to enter this market due to the complexity of the products that might not be well understood by small investors.

The SEC is investigating whether these funds provide adequate liquidity measures, maintain appropriate leverage ratios and exercise sufficient oversight through the funds' boards of directors. They plan to examine all trades, assess liquidity, monitor valuation and risk management policies of the funds and their sub-advisors, review stress test results and reference board meeting minutes.

Alternative funds permit the financial adviser to invest up to 15 percent of assets in illiquid investments. This represents the cost basis, not market value. As the market value of these illiquid assets rise, the percentage in the portfolio rises. Should the market experience a downturn that triggers redemption of liquid assets, the percentage will increase further. A high level of illiquid assets can contribute to high volatility and loss of liquidity in the markets, thereby harming the clients of the financial adviser.

The director of the office of compliance inspections and examinations at the SEC, Andrew Bowden, believes it is very risky for open-ended mutual funds to invest in illiquid and difficult-to-value securities.

The SEC is prudent to analyze this market to preclude the promulgation of excessive risk into an already fragile financial environment.