The Only Alternative: How Smart, Wealthy Investors Round Out Their Portfolios

Posted on: August 15th, 2014 by Gary Hager

road aheadBy Gary Hager, CFP(R)

What do the numbers 18, 24 and 29 mean to you?  Well if you invested in the alternative asset class of managed futures in 2008, those could have been your net returns.  Everyone else got crushed.  The lesson?  The old paradigm of asset allocation between bonds, stocks and mutual funds is dead.  The new paradigm goes well beyond the traditional portfolio mix.

That was what I wrote back in early 2009.   Since then, alternative investments have basically been in hibernation. Point being, alternative investments typically offer a negative correlation to equity markets. For the last five years or so the markets have gone virtually straight up.   Not a great time to be in alternatives.   But what does the future hold? At some point this bull is going to turn.   The question you need to ask yourself is, “What do I have in my portfolio to help me protect and take advantage of the next bear market?”

To generate consistent returns in the future, we need to start thinking outside the box.   Myriad investment opportunities abound outside of the equity markets and many have the potential to create positive returns in good and bad economies.

The most common road block for people who want to achieve a better-performing portfolio is time.  Most investors are also running a business, raising kids or busily climbing the career ladder; they have little spare time to investigate new investment opportunities, let alone delve into the seemingly complex alternative investment arena. Unfortunately, their broker often has limited exposure to alternatives as well.

My general advice to busy people is always, if you want to be wealthy just watch what smart and wealthy people do and copy them.  A good example is Harvard University’s endowment managers.  They have consistently generated excellent, stable returns and since 1980 they have gradually scaled down their exposure to traditional investments such as U.S. stocks.  They’re also increasing exposure to alternative asset classes such as absolute return strategies, real assets and emerging markets.  Why?

Alternative investments have very low correlation with traditional investments like stocks and bonds.  They include things like commodities, hedging, managed futures and private equity, as well as items such as, wine, art and antiques, which are rapidly rising in popularity.  The amount you allocate to alternatives will vary depending on your age and income, but exposure of 10% to 40% generally makes sense.

Adding alternative asset classes to a traditional allocation  a sound way to shore up a portfolio, especially in rougher markets.  They can help reduce portfolio volatility, and since they’re either negatively correlated or completely uncorrelated to stocks they have the potential to produce positive returns when stocks decline.   Will more difficult, volatile markets return?   I think the question is more when, versus if.   It’s really a matter of time.

A metaphor to explain  the balance that alternative investment brings, as in most things in life, is baseball.   A baseball team has nine players including outfielders, infielders, a pitcher and catcher.  Traditional investors only play the “infield” — stocks, bonds, mutual funds and cash.   When times are good, your opposition is only hitting ground balls to your infielders so your team is making plays and you’re winning games.   But in tough times, the opposition is hitting long flies and you have no “outfielders.”   Alternative asset classes are your “outfielders.”   They complete the team and allow you to win when most people are losing.

Of course, maintaining a winning streak without a good coach isn’t easy.   Most investors, especially busy and ambitious ones, benefit from having an experienced professional create their alternative investment plan.   Once you do decide to “play ball”, it probably won’t be long before your portfolio is off and running again.
Mr. Hager, a Certified Financial Planner, is CEO and Founder of Integrated Wealth Management with offices in Piscataway, and Parsipanny,  N.J.