Should You Include Alternative Assets in Your Portfolio?

Should You Include Alternative Assets in Your Portfolio?


Alternative assets cover a huge range of categories—essentially anything that’s not a stock or bond—running from the plain vanilla exchange-traded funds (ETFs) to the truly esoteric (e.g. timberland, fine wine, art collections). An important question for people as they manage their investment portfolios is whether they want to include alternative assets. And if they do, which alternatives are appropriate, and how do investors go about acquiring them?

Statistics Point in Both Directions

Data is mixed as to the effectiveness of alternative assets. A study from money management firm BlackRock shows that they offer returns close to that of stocks with reduced volatility.

Stocks generated annualized returns of 7.2 percent in the last 20 years, according to the report. Of eight alternative-asset classes, two surpassed that number: managed futures (7.39 percent) and real estate (9.11 percent). And three others came within 2 percentage points (global macro, long/short fixed income and long/short equity).

As for volatility, six of the eight alternative classes registered less volatility than stocks, and none of those six was even half as volatile as stocks. Only two classes were more volatile than stocks: commodities and real estate.

But statistics from investment research firm Morningstar, published in Wealth Management magazine, paint a more negative picture.

Those numbers show that a typical portfolio of 60 percent stocks and 40 percent bonds produced higher returns than a portfolio made up of 50 percent stocks, 40 percent bonds and 10 percent hedge funds for the one-, three-, five- and 10-year periods ended Sept. 30. And the hedge funds were more volatile than the bonds for every period. Of course, hedge funds are just one type of alternative asset. Other alternative assets would produce different returns and volatility—some higher, some lower.

Added Complications

Investing in alternative assets is often much more complicated than investing in stocks or bonds. Take, for example, managed futures funds, which invest in commodities and other assets. Fund managers have to deal with the rollover of their futures contracts: when contracts expire, the managers have to buy new ones. But there can be major price discrepancies between the new contracts and the expiring ones, which can create significant volatility for fund values.

Less liquid alternative assets (think coins, art, sports memorabilia) can give investors headaches due to their lack of liquidity. At any given time, it may be extremely difficult to determine the value of these assets. And if an investor wants to sell them, there is no guarantee that he/she will find a buyer.

If you do invest in alternative assets, experts recommend that you commit no more than 10 percent of your portfolio.

The Opportunities

So what are some of the most prominent alternative assets available to individual investors?

  • Gold funds. Perhaps the most popular of those investments are ETFs that invest directly in the precious metal. That means the fund’s value generally goes up and down in exact proportion to the price gold. Gold prices frequently rise in times of financial turbulence, so some investors use gold ETFs to hedge against the possibility of a stock-market plunge.
  • Hedge funds. Originally these funds were literally designed as a hedge—a hedge against declines in financial markets. But now many hedge funds seek to generate outsized returns. Possible investment strategies for hedge funds run the gamut. They may make a bet for or against bonds, or they may make a bet for or against the stocks of two companies likely to merge. Only accredited investors can buy shares in hedge funds—people with net worth of $1 million or annual income of $200,000.
  • Liquid alternative funds. For those people who aren’t accredited investors, asset management firms offer hedge-fund like strategies in a mutual fund or ETF. These offerings are known as liquid alternative funds. Some of them take long and short positions on stocks, while others hold non-traditional bonds, such as high-yield foreign debt. To be sure, Morningstar judges that most liquid alt funds, as they are known, have failed to add meaningful diversification benefits to traditional portfolios in recent years.
  • Commodity funds. Commodities often move differently than stocks and bonds, making them what’s called an uncorrelated asset. So there can be value to holding commodities as a hedge against declines by stocks and bonds. Most commodity funds are made up of futures contracts, similar to the managed futures funds above. Indeed, some of them are managed futures funds.
  • Real estate. The simplest way to invest in real estate is through a real estate investment trust (REIT). A REIT invests in real estate properties and trades just like a stock. So as a REIT holder you own a small stake in all the properties. A REIT must pay at least 90 percent of its taxable income in dividends each year, so you may earn substantial income. Real estate often moves differently than stocks, so it can provide a diversification benefit. Of course, you can also buy real estate directly, say an apartment building. But keep in mind that managing your own real estate is extremely complicated, and it’s very easy to lose money.
  • Art. People typically buy art through dealers, often at a gallery. Experts generally recommend that you buy a piece of art because you like the way it looks on your wall, not because you think it will increase in value. As mentioned above, determining a fair price can be difficult, because there’s no open market like for stocks. And no one may ever want to buy it from you, let alone at a price above what you paid for it.

 

So clearly alternative assets represent an area where investors can benefit from the guidance of an expert financial advisor. They can help you figure out whether alternative assets are right for you, and if so, how you should approach investing in them.

The views expressed by the author are not necessarily those of Fifth Third Bank and are solely the opinions of the author. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever.