When the stock market soars to new altitudes, as it has this autumn, there's usually uneasiness among many investors about a potential drop or correction, promoting concerns about portfolio volatility.
The age-old diversification strategy of reducing risk by moving more into bonds won't work so well in a rising interest rate environment, as this may increase risk rather than decrease it. So, many are looking for other means of diversification. Increasingly, they're considering alternative investments — broadly defined, anything other than stocks or bonds. The goal of owning "alts" is to add to portfolios risk/reward potential that's not correlated with the movements of stocks or bonds, aka traditional investments.
Access to many alternative investing options is readily available through various exchange-traded funds, including those owning commodities, currencies, managed futures and real estate investment trusts. But this easy access can get you into trouble if you don't take the time to learn about the unique risks an alt may carry. Understanding some alts and their risks may require more homework than most individual investors are willing to take on.
This might apply to commodities, which can be downright esoteric. For example, agricultural commodity investing involves understanding how yields of particular crops may be affected by changes in seasonal weather patterns. And how much time are you willing to invest in studying supply/demand for rail cars?
In the run-up to the financial crisis of 2008, complexity didn't seem to bother a lot of (or enough) investors who bought the granddaddy of indecipherable alts — derivatives. Yet there's as much complexity in many alts that are far less abstract than derivatives. Just because a commodity is concrete doesn't mean it's not complicated.
REITs can be counted among the more accessible alts, and they can deliver good returns while diversifying risk. Yet investors must be mindful of the differences between various real estate markets. For example, residential REITs recently have been doing quite well, driven by demand that's still somewhat pent up from the market doldrums of the financial crisis of 2008.
But some commercial REITs, such as those that depend on mall rents, are another story now that online retailing is bruising many bricks-and-mortar chains. Instead of places where people walk around to shop, think warehouse space/fulfillment centers for online retailers and server space for the rapidly growing cloud storage industry.
Regardless of the category, alt investing can be costly, and the high fees sometimes involved can significantly reduce your net returns. A recent study by the Boston Consulting Group found that, at the end of 2016, alts made up about 15 percent of global assets under management but accounted for 42 percent of the fee revenue generated by asset management firms offering alts.
Yet fees involved are easy enough to determine in advance. The most difficult thing about alts is understanding the peculiarities of different specific alt markets. To understand the risk levels of myriad alts, individual investors must approach this unfamiliar terrain with the right mentality.
To keep the new allure of alts from causing you to crash your portfolio on the rocks of poor choices — or, in the case of minimal investment, allowing it to be whittled down — consider these basic questions:
- Is the alt you're considering truly and consistently not correlated with stocks or bonds in terms of both risk and source(s) of return? This is essential, but keep in mind that lack of correlation isn't a virtue in and of itself. In their quest to diversify, investors can lose sight of their primary goal: to get positive returns. Master limited partnerships may have looked good a couple years ago, when it was widely assumed that oil prices were going to rebound quickly. But when that didn't happen, many investors lost their shirts. Instead of uncorrelated losses, you want real potential for uncorrelated gains.
- What's your purpose in adding a particular alt? That is, what would be its role in your portfolio? How would this investment interact with the rest of your portfolio? Instead of reflexively sprinkling in alts, develop a rationale for using each alt strategically — or don't buy them.
- What are the inherent risks involved in a given alt? This may only be revealed by close study — possibly too much to justify considering it.
- How much of an alt should you add to your portfolio? If you're an individual investor spreading your alt dollar over a few different types, the answer probably is "not much."
- What percentage of your total portfolio should be in alts? This depends on your overall portfolio goals, risk tolerance and time horizon.
"Alt investing can be costly, and the high fees sometimes involved can significantly reduce your net returns."
It's important to remember that alts aren't the only way that the diversification-conscious can deal with the coincidence of the stock market's being at all-time highs and the end of the 30-year bull bond market. You could maintain a sizable allocation to bonds and still protect yourself by keeping maturities short. Or you could build a bond ladder with greater allocations for the short term (a year or two out) and smaller for longer terms (five years of so). Or you could combine this adjusted bond strategy with alts.
Thus, an adjusted approach to diversification, tailored to your specific situation, might involve alternatives to alts.
— By Eric C. Jansen, founder/president and chief investment officer of AspenCross Wealth Management