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Stocks and bonds should be your portfolio's bedrock: a solid foundation to generate growth and income that lasts through your retirement. But adding some "alternative assets" may help smooth your returns and could boost them in the long run, according to some analysts and financial advisers.
Alternative investments run the gamut from commodities and real estate to more exotic assets like private equity and hedge funds. These types of investments are now used routinely by the professional investors who run pension funds and college endowments. These market pros expect to have 25% of their assets in alternatives by year-end, up from 23% in 2011, according to a study by consulting firm McKinsey & Co.
Alternatives are gaining popularity with individual investors too. Dozens of funds using alternative strategies have launched in recent years, and there are now 262 such funds on the market with more than $120 billion in assets, according to Morningstar. Alternative ETFs have proliferated as well, holding another $140 billion. Among advisers, 41% think that alternatives have become "more important than traditional investments," according to a 2011 survey conducted by Morningstar & Barron's.
One reason to use alternatives: They don't always move in the same way as traditional stocks and bonds. That can help diversify a portfolio and boost returns in periods where stocks or bonds may be weak, says Mitch Reiner, a financial adviser with Wela Strategies in Atlanta. "We like alternatives in portfolios where clients want upside," but also want their lows to be less severe, he says.
Gold, for example, is viewed as a way to help protect your investments against inflation and can help offset risks elsewhere in your portfolio. The ups-and-downs of gold bear little correlation to those of stocks, according to research from Deutsche Asset Management. The precious metal also has a low correlation to most other assets, including, bonds, real estate investment trusts (REITs) and other commodities.
In addition, gold is likely to rally if the dollar weakens — which some analysts think is possible due to the big increase in the U.S. money supply and the potential for higher inflation down the road.
Commodities (other than gold) may help diversify your portfolio too. Commodities do best when inflation and interest rates are rising — periods when most other financial assets tend to decline, according to Deutsche Bank. Commodities don't move closely in tandem with stocks, bonds or emerging-market debt. They also tend to hold up in the early stages of a recession when stocks usually fall, according to research from S&P Dow Jones Indices.
While alternatives may boost your long-term returns, most advisers still recommend stocks and bonds for the core of your portfolio. That's because alternatives may not always live up to their billing as a diversifier and could hold back your returns.
Risky assets of all kinds are now moving more closely in line with each other, including alternatives. For example, the only safe havens during the market crash of 2008-2009 were cash and U.S. Treasury bonds. Since then, correlations between risky assets have remained well above average, making alternatives a less effective diversifier, says Scott Kuldell, director of portfolio management for managed accounts at Fidelity Investments.
Another drawback is costs. The median expense ratio for alternative mutual funds is 1.44%, according to Morningstar, well above the 0.99% for large-cap U.S. growth funds. ETFs tend to have lower fees. But trading costs can add to your expenses and many alternative ETFs suffer from "tracking error"— failing to closely match the returns of the index or commodity they're supposed to track.
"Any time fees and costs are high, it's a big drag on returns," says Bob Seawright, chief investment officer of Madison Avenue Securities, a brokerage and investment advisory firm in San Diego. Indeed, gold and commodities aren't like stocks or bonds that generate income from dividends or coupons; without those income streams the only way to make money off commodities is by raising prices — while the costs of holding them rack up.
Finding good alternative managers poses a challenge too. Hedge funds and private equity aren't available to most investors. That leaves high-fee funds on the table, and their track records have been poor. The alternative mutual fund category returned just 2.2% annually over the last three years, according to Morningstar, compared to 11% gains a year on average for the S&P 500 (.SPX).
To some extent, it makes sense that these funds would lag. Their high fees hurt performance and many use "long/short" strategies, using a portion of their assets to bet that individual stocks or the broader market will decline. In a rising market, that caps the fund's upside.
"The argument is that alternative funds will do well in every environment," says Seawright. "But to this point, they haven't delivered."
While there's no perfect alternative, adding some gold, commodities and other assets that tend not to move in lockstep with stocks and bonds still makes sense, says Reiner, the Atlanta adviser. For an investor in her mid-50s who can handle moderate risk, he recommends putting 10% into alternatives. Younger investors may want less alternatives because their time horizons are longer and they don't need as much downside protection.
However you decide to go, it's important to determine how alternatives fit with your other investments. An adviser can help determine if they're right for part of your portfolio or whether a mix of stocks, bonds and cash is more suitable. Here are a few ideas, but they're only suggestions. You should always do your own research or consult an adviser, if necessary, before investing.
Commodity ETFs have been poor performers as inflation has stayed tame. Indeed, Fidelity's Kuldell isn't recommending commodities, arguing stocks offer better potential returns with similar risk.
Yet if inflation creeps up, commodities are likely to shine, according to Morningstar analyst Abby Woodham. One ETF she recommends: the GreenHaven Continuous Commodity Index Fund (GCC), which tracks an index of 17 commodities, each equally weighted.
Given that structure, the ETF offers more exposure to grains, livestock and other "soft" commodities, and much less energy, than many of its peers. Indeed, its 18% energy exposure is a fraction of ETFs like the iShares S&P GSCI Commodity-Indexed Trust (GSG), which tracks an index that has 69% in energy. While that may be a drag on the GreenHaven ETF if energy prices rally, the fund has generated "strong relative performance and lower volatility," Woodham notes.
Keep in mind, the ETF is still 80% as volatile as the S&P 500. Annual fees are above-average at 1.05% and the ETF could generate taxable income even if investors don't sell, due to the fund's structure as a limited partnership.
For gold exposure, SPDR Gold Shares (GLD) is the largest and most liquid ETF in the space and makes sense for investors who want gold, says Reiner. The ETF is backed by physical gold bullion held in London vaults and has done a good job of tracking the price of the spot commodity, according to Morningstar analyst Abraham Bailin.
Granted, gold has rallied sharply in recent years and pulled back at the end of 2012. Some analysts think the gold bull market is over or due to pause. But there are some reasons it may continue, including growing gold imports in China. Some analysts also expect gold to hold its value as a source of protection against a weaker dollar and inflation down the road.
The downside: The ETF costs 0.40% in annual fees, making it a bit pricier than the iShares Gold Trust ETF (IAU), which charges 0.25% (though it's not quite as liquid or large). Gains are taxed at up to 28%, the IRS rate for "collectibles." And the ETF could be a poor investment if the dollar strengthens, which would weaken demand for dollar-based assets such as gold.
Investing directly in real estate by buying and renting a property can be a good way to generate income and participate in the improving housing market. But you need a lot of cash up front, as well as the time and money to maintain the property.
An alternative? Real estate investment trusts (REITs), which offer similar diversification benefits and generate income too.
In the short run, REITs tend to move in line with stocks but longer term, REIT returns are driven more by property values and income streams from rents, according to research from JP Morgan Asset Management. Indeed, U.S. REITs returned an average 10.2% a year from 2001 to 2011 while the S&P 500 generated 2.8% returns a year.
For investors who want exposure to global real estate, Morningstar analyst Bailin recommends the SPDR Dow Jones Global Real Estate ETF (RWO). The ETF tracks an index of global real estate stocks and invests mainly in countries with mature real estate markets, such as the U.S., Western Europe and Japan. While the ETF is less volatile than the S&P 500, 10% of its assets are in Asian markets such as Hong Kong and China, which can be volatile. The ETF costs 0.5% in annual fees and yields 3.9%.
For more on real estate investing, see 8 real estate investments yielding up to 7%
While many funds have jumped into alternatives, few are no-load, have low minimum investments or sport well-established records. High fees make it challenging for these funds to beat their benchmarks too. Still, a few funds may be worth considering.
DWS Select Alternative Allocation (SELEX), for instance, has beaten the alternative category average over the last three years, according to Morningstar. The fund invests in 15 other DWS funds and ETFs, including a "market neutral" strategy, bank loans, commodities, real estate and global timber. The managers rebalance the mix regularly and try to keep the returns stable. "We're focusing on dampening volatility and providing consistent returns over time," says Douglas Beck, president of DWS Funds.
Indeed, the fund is less than half as volatile as the stock market, according to Morningstar, and it returned 5.9% annually over the last three years, beating 73% of alternative funds.
The downside: The fund isn't likely to soar when stocks are rallying. It trailed the S&P 500 by 7.5 percentage points annually over the last three years. The expense ratio is high at 2.6%. Plus, there's a $75 transaction fee to buy shares on the Fidelity platform.
Another alternative is a "merger arbitrage" fund. These funds buy the stocks of acquisition targets and hold them until the deals close. Shares of the target company typically rise to the acquisition price. The fund may also "short" an acquiring company, betting its stock will go down. The strategy doesn't depend on the market's direction and is designed to deliver steady gains, according to Morningstar analyst Mallory Horejs.
One fund she likes: the Merger Fund (MERFX). The managers have more than 15 years of experience with the strategy, she notes, and returns averaged 3.4% annually over the last five years, beating 95% of alternative funds. Volatility is a fraction of the S&P 500 and the fund charges 1.37% in annual expenses, well below average for alternative funds.
The caveats: The fund is likely to return a fraction of the market when stocks are rallying. Deals sometimes get cancelled, saddling the fund with losses. And it's not tax-efficient. The fund's distributions are considered ordinary income, making it best held in a non-taxable account.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services. He does not own any of the securities mentioned in this article.
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