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Variety Can Mean Vitality For Your Portfolio

Published: Monday, 31 Aug 2009 | 2:22 PM ET

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By: Shelly K. Schwartz,
Special to CNBC.com

In a market characterized by manic mood swings, it’s hard to stomach the notion of adding alternative asset classes—which can be very volatile—to your portfolio.

Mutual Funds
modowd
Mutual Funds
Yet, a little exposure to commodities, commercial real estate and mutual funds that emphasize hedging strategies may be just the fix you need to keep your investments fat and happy in both good times and bad.

“I think investors are becoming more and more aware of alternative funds because of the volatile markets and I think they have more of a place in the average portfolio now because of market uncertainty,” says Nadia Papagiannis, Morningstar’s lead alternative investment analyst.

The biggest benefit of alternative assets, of course, is their low (and sometimes negative) correlation with stocks and bonds. That means they perform independently of Wall Street’s ups and downs, which helps reduce volatility in your overall portfolio and minimizes downside risk.

Alternative Investing - A CNBC Special Report - See Complete Coverage

Because their price swings can be dramatic, however, particularly in the case of commodities, alternative investments are often viewed as volatile—though there are alternative funds that seek to maintain an even keel.

As such, it’s important to maintain an appropriate allocation to non-traditional assets. Financial advisors say real estate investment trusts and commodities, for example, should comprise no more than five to ten percent of the average portfolio.

The other downside to alternative assets is that they’re, well, intimidating. Terms like arbitrage, derivatives and options, are enough to send most investors running for the relative safety of blue chip stocks, even if they're looking black and blue.

Slidehow: From Coins to Commodities and Beyond

Over the years, however, a number of fund products have materialized to help investors take advantage of the diversification benefits of non-traditional assets while reducing their risk and, most importantly, holding the hand of a professional (if pricey) fund manager. That's especially true for investors who can't afford the high price of entry for hedge funds.

Mutual Funds

Mutual funds that focus on alternative strategies are one way to give your portfolio some downside protection.

Long-short funds, for example, take both bullish and bearish positions on the market by buying stocks outright (going long) and short-selling (selling borrowed securities with the hope of buying them back at a later date for less). Short sellers profit when the price of the
security falls.

Such funds fall into two main categories: traditional long-short funds and market-neutral long-short funds.

Traditional long-short funds, which seek to profit in any market, have a relatively high exposure to equities and are therefore more volatile, says Papagiannis.

“These funds can be a core holding in anyone’s portfolio as a way to lower your risk, especially if you think the market is going to experience some ups and downs over the next few years,” she says. “Protecting wealth is very important to portfolio management so strategies that can minimize your risk of loss can play an important role.”

Market-neutral, or low-correlation, long-short funds, on the other hand, seek to insulate investors from stock-price swings by maintaining an even balance of both short and long positions.

“Returns are generally not staggering, but neither is the risk,” says Papagiannis.

Just be sure to keep an eye on those expense ratios.

“Alternative funds tend to have higher expenses and that doesn’t necessarily mean they’ll underperform as a result, but over the long run we’ve seen that funds with higher expenses do tend to underperform,” says Papagiannis, who notes the Hussman Strategic Growth Fund [HSGFX Loading... () ] is a solid performer with a “very low expense ratio for what they do.”