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.
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.
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.
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 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
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 is a solid performer with a “very low expense ratio for what they do.”
Commodities, which are raw materials such as wheat, oil, copper and other natural resources, offer similar diversification benefits because of their low-correlation with stocks and bonds.
They also provide inflation protection, since the price of raw materials tends to rise when inflation is accelerating. But they can be volatile—very volatile—and subject to boom-bust cycles.
The S&P GSCI Commodity Index, for example, is up more than 9 percent so far this year, but down nearly 50 percent over the last 12 months. Its three-year return is off by 36 percent.
By comparison, the S&P 500 has returned better than 15 percent year-to-date, but is down roughly 18 percent for the year, and off 15 percent over the last three years.
Despite their dismal performance in 2008, however, Morningstar analyst Arijit Dutta writes in a recent report that “a limited allocation [to commodities] to serve as an inflation and a market risk hedge is still quite justifiable. Don’t lose sight of the asset class’ fundamental merits because of what happened last year.”
He adds: “There are a few good, reasonably priced natural-resources funds where management can identify solid companies, but your best bet for long-term strategic allocation to commodity prices is through a futures fund.”
Indeed. At one time, investors seeking commodity exposure were forced to purchase futures contracts, an agreement to buy or sell a commodity at a specified price in the future, or to buy an option on a commodity futures contract, which gives you the right to convert your option into a futures contract.
Today, there’s an easier way.
Index funds, like commodity exchange traded funds (ETF), are traded like stocks and track the price of either a single commodity, such as wheat or oil, or a bundle of commodities, like a mutual fund, making it easier to buy and sell for a smaller minimum investment.
You can also purchase commodity exchange traded notes (ETNs), which are not funds at all, but 30-year debt securities with track the major commodity indexes. Investors can buy and sell them through a broker on the New York Stock Exchange.
Morningstar’s top pick in the category? Elements S&P CTI ETN.
Real Estate (REITs)
Real estate investment trusts (REITs) represent yet another alternative for investors looking to balance out the bumps in their portfolio—and they’re typically less volatile than commodities.
Equity REITs are companies that own and operate income-producing properties, like apartments, industrial spaces, shopping centers, offices and warehouses.
Mortgage REITs, meanwhile, provide debt financing for commercial and residential properties through their investments in mortgages and mortgage-backed securities.
REITs are traded like stocks, allowing investors to add commercial real estate to their portfolios without having to commit a huge down payment or sacrifice liquidity.
They are also required to distribute at least 90 percent of their taxable income each year to shareholders through dividends – creating a reliable income stream.
According to the National Association of Real Estate Investment Trusts, the All REIT Index is up nearly 9 percent so far this year through Aug. 24, up significantly from its 37 percent decline in 2008, and 18 percent drop in 2007.
“We have a neutral outlook on the REIT industry in general,” says Bob McMillan, a REIT analyst for Standard & Poor’s. “People were pricing [REITs] as if they were going to go out of business [during the last two years] and there are definitely challenges facing the industry, but over the longer term we think there are also opportunities for some of these companies, in particular retail REITS, to improve from both an operating perspective and a share price perspective.” Currently, S&P has Simon Property Group as a “strong buy.”
“We think [SPG] has a good portfolio of properties that have held up well in this recession, including regional malls, community shopping centers and premium outlets,” says McMillan.
“Even in this economy people are still shopping and looking for value, and their outlets cater to that segment, but eventually as the economy recovers other segments of their portfolio will also benefit.”
For the very brave or adventuresome investor—especially the tactile kind—there's an alternate universe of investment out there, known as collectibles. There's real money in these real objects, and you almost always have something to show for your investment—gain or loss. From art to coins to stamps to wine, these investments present opportunity—and risk, of course, for the knowledgeable investor.
As you tally up your losses from Wall Street’s latest meltdown, it helps to remember there’s a world beyond stocks and bonds.
Funds that focus on alternative assets are giving investors more tools to diversify than ever before, enabling them to better manage downside risk.
Just be sure you know what you’re buying, the risks involved, and how it fits into your overall investment goals before jumping in.