If you do a Google search on “Alternative Investments” you get nearly 11 million results, which is incredible. The key question is why are people doing searches on alternative investments? Let’s explore…..
Alternative investing originated in the institutional world via corporate and public pension funds, foundations and endowments, and other large investment pools. They can be defined as investments that seek to accomplish their objectives by investing in investments that go beyond owning purely stocks and bonds. The most popular alternative vehicle has been hedge funds. Hedge funds are not typically registered with the SEC, although more are becoming registered for transparency reasons. Hedge and/or alternative funds do more than just buy and sell stocks and bonds. They are able to use leverage (borrow against securities to purchase securities), sell stocks shorts (betting that stocks will fall and making money off those bets), sell bonds short, or simply making bets that interest rates will rise or fall, buy distressed debt, buy distressed real estate, currency movements, managed futures, among a variety of other strategies.
Investors still shell-shocked by the 2007-09 stock market catastrophe and anxious to cushion future stock market losses are taking notice of alternative investments in a big way. From the end of 2007 through the end of 2013, assets in alternative mutual funds and other securities like exchange-traded funds (ETFs) more than tripled, to $184 billion according to Morningstar. As a result, many fund firms have created funds solely on alternative strategies in-house and/or hiring experienced hedge-fund- like management teams to run them. The mutual fund industry is quick to pounce on taking advantage of unique investment opportunities and alternatives certainly fit the bill. Morningstar, Inc., the popular mutual fund rating firm, even established an entire research center devoted to alternative mutual funds. Mutual funds have made investing in alternatives much easier because they don’t have high minimum investments that hedge funds require, and there is more public information available to analyze funds. For most retail alternative mutual funds, investors can get in for as low as $1,000.
I believe the advent of these new strategies in a mutual fund format is a positive thing for the industry, but investors need to do their homework before considering using them in their portfolios. The premise behind wanting to invest in alternative mutual funds is that they may provide diversification benefits to traditional stock and bond portfolios. If the stock market falls, some alternative strategies may hold up better, thus cushioning declines and preserving capital.
As I noted earlier, the main premise behind using these alternative funds is they offer another way to earn returns other than relying purely on stocks and bonds. However, I think these strategies tend to work better when they are combined with traditional stock and bond funds as opposed to using them as singular investments. While some of the alternative mutual fund strategies are similar (mostly in name only), most of them are dissimilar and can be challenging to understand, even for experienced investment advisors. Therefore, I believe the following are some helpful points to consider before deciding to use them in long-term investment portfolios:
Determine the role they play in your portfolio. This is the most important criterion. They should play a more supporting role in a portfolio and not a major role, meaning the percentage you own should be small relative to ownership in more traditional stock and bond funds. What are you trying to accomplish by including them in your portfolio—volatility dampener? Additional returns? I don’t know if these investments will become mainstream, but their role in portfolios needs to be analyzed carefully before deciding to use them.
The strategy you select is important. The alternative strategy you select is important, and figuring out which one to use is often challenging. Fortunately, Morningstar, Inc. created an alternative research center a few years ago that is devoted to analyzing and even rating alternative mutual funds, so they have made it easier to research them. But it’s important to understand how these strategies perform when stocks are doing well and doing poorly. Some of these funds perform differently if interest rates are going up or down as well. It is critical to understand how they perform in various market environments so you don’t get caught off guard when they don’t meet your objectives.
The management team/mutual fund you select is important. This is another critical point since experience managing alternative strategies is important. It is important because they are complicated strategies and understanding how management invests money should be a deciding factor. Morningstar unfortunately doesn’t cover all of these strategies, but for simplicity purposes, I would choose funds that Morningstar analyzes as a way to sift through the below average funds, of which there are many. I recommend sticking with funds that have proven leadership, experience, and reasonable expenses. Like all mutual funds, you need to be aware of the fees that are charged when you are deciding which alternative funds to invest in.
Finally, it is also important to keep your expectations in check regarding these types of investments. While they may work well to cushion market volatility, their performance may lag when the stock market is doing well as it has over the past five years. Understanding how a fund performs in various market environments will you ignore negative stories about how poorly these funds work when stocks are in a bull market.
As investors, we can’t predict the direction of the market, but we can certainly be smart about building diversified, multi-asset class portfolios, whether they include alternatives or not.