The alternative to alternatives

"There aren't bad investment products, just poor uses for them." This was a line I was taught to parrot years ago in my training at one of the world's largest insurance companies. But while clever and convenient, it's complete and utter nonsense.

A great number of investments simply don't deserve your—or anyone else's—attention or dollars. Many of them fall into the mystical category of "alternative investments."

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In truth, "alternative investments" is entirely too broad to mention as a single category, because it is made up of many classes of investment products. While hedge funds and private equity have all the sex appeal, thanks to their super-selective vibe, the most readily available, and occasionally useful, alternatives are in areas such as real estate, commodities, annuities and Treasury Inflation Protected Securities (TIPS).

What nearly all alternatives have in common, however, is also their greatest weakness: mind-bending complexity. They're so complex, in fact, that even many financial advisors don't know or can't explain how they're created or what they do. No stranger to confusion myself, I sat down with two notable experts on the subject—my colleagues Larry Swedroe and Jared Kizer—to delve further into alternatives.

Swedroe is a principal of BAM Advisor Services, and Kizer is director of investment strategy at BAM, a community of more than 130 independent wealth management firms.

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Swedroe and Kizer teamed up to write a book called "The Only Guide to Alternative Investments You'll Ever Need," which in itself says a lot. But Swedroe also pointed me to the book's subtitle, "The Good, the Flawed, the Bad and the Ugly," as an introduction to his opinion on this topic.

"We had to stretch a little to create a 'good' category for alternatives," Larry told me. "In general, you should be skeptical of them."

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But why? "Because the financial industry is great at creating demand through marketing for products that don't necessarily need to exist," he said.

It appears that Apple wasn't the first company to take advantage of the whole this-is-new-and-you-need-to-have-it marketing strategy. The financial industry has been doing it for more than a century, and the pace seems only to have quickened.

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What alternatives do deserve our attention? While theirs is not an exhaustive list, Kizer and Swedroe agreed that real estate, through real estate investment trusts; commodities (but only broad commodity holdings); and inflation-adjusted securities—such as TIPS, in one's fixed-income allocation—could be used to good effect in many people's portfolios, but in limited quantities, especially for real estate and commodities.

"Real estate and commodities aren't likely to make or break a portfolio over the long term," Kizer said. "The primary benefit we derive from alternatives is not the enhancement of long-term returns, but broader portfolio diversification."

Alternatives shouldn't comprise more than 5 percent to 10 percent of the equity portion of one's portfolio, according to Swedroe and Kizer. They are, therefore, less of a vital asset class and more of a, well, alternative consideration. Alternatives can be utilized well, however, in limited quantities and in proportion to risk factors unique to you or your portfolio.

An example where alternatives clearly make good sense would be in the case of a retiree for whom a meaningful portion of his or her income is covered by a corporate pension with no inflation adjustment. Here, a broad commodity index may be advisable. Buying gold alone, however, may not be advisable for this retiree, because gold is more of a geopolitical instability hedge than a pure inflation hedge.

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Of course, the inverse is also true. If you have a portfolio of rental properties, there may be no need to further increase your overall exposure to real estate by mandating a REIT allocation.

If at all possible, any alternative holdings in your portfolio should be in tax-privileged accounts, such as an IRA. Indeed, the benefit of alternative investments begins to erode in taxable accounts because of their nearly universal tax inefficiencies.

What about hedge funds and private equity, in particular? The consensus seems to have changed little for Swedroe and Kizer. They believe that if you can get access to it, you probably don't want it. If the hedge fund or private equity offering needs your money, it means that the "smart money" has already turned them down.

But quite possibly the biggest problem with alternative investments is that investors don't stick with them. We know this is a problem with investments of any variety when volatility reigns supreme, but in their study, "Higher risk, lower returns: What hedge fund investors really earn," Ilia Dichev and Gwen Yu concluded the following:

"Our main finding is that annualized dollar-weighted returns are on the magnitude of 3 percent to 7 percent lower than corresponding buy-and-hold fund returns."

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In other words, while reports of higher returns for hedge funds—relative to "the market"—have been debated, there's no question that the actual returns of hedge fund investors are far lower than the returns of the investments themselves.

This leads us to Swedroe's ultimate litmus test for any investment in your portfolio, but especially alternative investments. Given their complexity, he said, "never own an investment unless it is fully transparent and you understand it well enough to explain how it works to a 15-year-old."

Swedroe's reasoning here has nothing to do with performance—it's about behavior. If you don't fully understand how an investment functions, the chances are much higher that you'll bail out at exactly the wrong time.

"We need to be confident enough in every part of our investment strategy to stay the course, lest the whole strategy crumble."

The one guarantee of investing, after all, is that every asset class will eventually test the resolve of every investor with poor relative performance.

We need to be confident enough in every part of our investment strategy to stay the course, lest the whole strategy crumble. If that means alternative investments shouldn't be part of your portfolio, then consider good old-fashioned, simple, disciplined, diversified, evidence-based portfolio management—the alternative to alternatives.

—By Tim Maurer, special to Maurer is director of personal finance at the BAM Alliance.