- Increased market volatility may prompt more investors to consider alternative investments.
- Assets that are not correlated to the markets can include everything from private equity and hedge funds to liquid alternative exchange-traded and mutual funds.
- Investors need to carefully consider whether they can withstand a potential lack of liquidity, depending on the investment, and whether they can withstand any losses.
When the markets experience sudden drops, most investors hope the value of their investments doesn't go with them.
Non-correlated assets, or so-called alternative investments, offer the potential for at least some of your assets to stay put when the markets hit the skids.
And more investors seem to be warming to areas outside of traditional equities and bonds in light of recent market volatility.
"We've started off 2019 with almost as many 1 percent moves in the broader market as we did in some prior years for the whole year," said Todd Rosenbluth, director of ETF and mutual fund research at CFRA. "There's likely to be growing interest in alternative strategies as investors want to protect themselves and advisors want to use strategies to smooth out the ride for their clients."
A December survey of 500 high-net-worth investors found that many are turning more to areas such as private equity, real estate and hedge funds. Meanwhile, those investors, who have portfolios of $250,000 or more, are slowing down their allocations to traditional stocks, bonds and mutual funds.
"This volatility has created an awareness of the need to diversify," said Gary Anetsberger, CEO of Millennium Trust Company, which conducted the survey.
That even goes for average investors, who have exposure to the markets through their 401(k) plans, individual retirement accounts or stocks. "Everybody is highly concentrated in the stock market right now," Anetsberger said.
Investors need to keep in mind that the definition of alternatives is pretty broad and can vary from firm to firm.
"If we're thinking of diversifying alternatives, you're really looking at different strategies that don't necessarily depend upon the direct returns of stocks or bonds," said certified financial planner Barry Glassman, president of Glassman Wealth Services.
Certain risks come with each type of investment.
Real estate can be considered an alternative investment. And while it was not correlated to the markets during the tech bubble bursting, real estate was definitely affected during the financial crisis, Glassman noted.
Private equity is another area investors tend to turn to, but how well those funds do is often tied to the global economy. "The returns were certainly correlated during the financial crisis," Glassman said.
Hedge funds can also be used to diversify, though they are risky. "Their performance is not better, and in many cases worse, than the general market," said Mark S. Germain, a CFP and managing director at Mercer Global Advisors.
Gold and other metals can be used as an inflation hedge, according to Germain. "At the current time, we don't see inflation as a big concern," he said.
The ample risks mean that most advisors will limit how much of a client portfolio they allocate to alternatives. Germain said his clients may have anywhere from 10 percent to 20 percent in alternatives, depending on their assets and risk tolerance.
Investors also need to carefully consider whether they can handle the limited ability to cash out that comes with some of these investments.
"People need to understand how much they can live with on the lack of liquidity side," Germain said. "Some people can't live with it at all, and if they can't, the alternative asset class is not for them."
Investors may also be able to add alternative investment strategies to their portfolios through ETFs or mutual funds that aim to provide protection when markets go down.
The advantage of those funds is that they offer daily liquidity. The challenge, however, is picking the winning strategies.
One approach that may be popular in 2019 is merger arbitrage funds, Rosenbluth said, after the year kicked off with strong M&A activity. The funds typically work to earn a spread between buyers and sellers on pending mergers.
One mutual fund called the Merger Fund had a standout performance last year, when it was up 7.7 percent. But that was an anomaly, Rosenbluth said. In 2017, it was up only 2.4 percent.
The performance highlights the risks of investing in alternative strategies. Funds within each category may do well or poorly, according to Jason Kephart, a senior analyst focused on alternative funds at Morningstar.
For example, the worst-performing long-short equity fund was down 22 percent last year, while the best-performing fund was up 12 percent. The average for that category last year: negative 6 percent, according to Kephart.
"Picking the right manager matters more than picking the right category," Kephart said.
And if you can't stomach those losses, you might want to avoid alternative funds altogether.
"Not everyone needs alternatives," Kephart said. "There are a lot cheaper and easier ways to lower your risk.
"You can add cash or short-term bonds, which are going to lower your volatility."
Many investors who invest in alternative mutual or exchange-trade funds lose out by trying to time their investments.
"It's so easy to cash out after a year of bad performance," Glassman said. "They buy in after it does well and they cash out after it's done poorly."
If you invest in one of these strategies, you need to have the resolve to stick with it. Otherwise, you risk leaving returns on the table.
You may also be able to invest in alternative investments directly through your retirement funds. But that should come with a big warning sign, according to Ed Slott, founder of Ed Slott & Co.
"As soon as the markets get shaky, people look for the grass to be greener somewhere," Slott said. "And they always get themselves in trouble, almost all the time."
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Tax rules dictate that you can invest in anything in your IRA except for collectibles, life insurance or S corporations.
But if the investments you make through your IRA are not liquid, you could have a difficult time taking your required minimum distributions once you turn 70½.
You could also run the risk of running afoul of prohibited transaction rules that come with severe tax penalties — losing as much as your entire IRA.
That goes if you invest in real estate through your IRA and then use the property for your own purposes, otherwise known as self-dealing.