When selecting the appropriate alternative strategies for a portfolio, it's important to examine one's existing holdings. Although most investors would consider a standard 60% stock and 40% bond portfolio to be "diversified," more than 90% of the risk in this type of portfolio comes from the equities. See
. In this case, it can be prudent to diversify some of the equity risk in a portfolio.
Adding a long-short equity fund could help to reduce the risk of a stock-heavy portfolio, although it will still incur some of the ups and downs of the equity markets. Adding a managed futures fund may allow an investor to achieve similar returns to equities, but unlike long-short equity funds, managed futures funds do not always move in the same direction as the equity markets, which may provide valuable diversification.
Although equity risk is of great concern for many investors, there is also risk in bonds, especially in a rising interest rate environment. One alternative to bonds is a market neutral fund, which offers similar levels of potential risk and return but does not take on credit or interest rate risk. Similarly, a currency fund offers relatively low risk and return characteristics, but because many currency funds bet against the U.S. dollar, they are likely to provide uncorrelated returns. Finally, a nontraditional bond fund, which hedges against interest rate or credit risk, may help to offset any losses in traditional bond funds.
It is important to remember that the goal of alternative investments is to diversify and reduce the risk in one's portfolio, thereby improving the overall risk-adjusted return of the portfolio. It's true that investing in alternatives may sacrifice upside return potential, but by avoiding large losses, alternative investments could actually build wealth faster over time.