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By Christine Benz | 12-07-2010 06:00 AM

Alternatives: When, Why, and Which Ones?

Alternative investment strategist Nadia Papagiannis outlines the role of alternatives in a portfolio, what to avoid, and two picks to consider.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Many alternative investments for individual investors have proliferated over the past several years, but investors often struggle with whether to add them, and if so, which ones.

Here to discuss that question is Nadia Papagiannis. She is alternative investment strategist for Morningstar.

Nadia, thanks for being here.

Nadia Papagiannis: Thanks for having me.

Benz: So let's start with a general question. How do you define "alternative," because a lot of things get thrown under that broad umbrella?

Papagiannis: Everybody has a different definition, but at Morningstar, we define alternatives as investments that invest in different asset classes or different strategies, meaning they short or they hedge, and the result is their return profile is going to be different than traditional stocks and bonds. So it's going to kind of zig when stocks and bond return to zag, and that's the idea of lower correlation.

Benz: Right, so I'll confess. I come at this as a little bit of a skeptic. I'm wondering if you can talk about what you think alternatives add versus a portfolio that's composed of traditional asset classes like stocks and high-quality bonds.

Papagiannis: I would say the defining characteristic of an alternative investment is risk management, and that's something that's really not found in your long-only stock or bond funds, and managers can manage risk by shorting or by hedging, and what that accomplishes is a return profile that's probably not going to have as much of an upside, but it's going to have a lot lower downside. So over the longer term you're going to have it better risk adjusted return.

Benz: So you're saying that if you add an alternative investment to a portfolio that includes traditional asset classes, you'll reduce the overall risk profile.

Papagiannis: Right, and you'll improve the risk-adjusted return of the overall portfolio. And a lot of people think that they are sufficiently diversified with just stocks and bonds, and they look to 2008 when U.S. Treasury bonds did really well, and basically they were the only asset class that had positive performance in 2008. And so many investors came out of that thinking, well, I can just pile into Treasury bonds and then I'll be sufficiently diversified against another market crash.

Well, that's what a lot of investors have done, and in fact, lot of money is in Treasury bonds and corporate bonds right now. But there is a big risk in that right now, and the risk is that although Treasury bonds have done particularly well over the last couple of years, especially on the longer end of the yield curve, there's also been a lot of volatility in the longer end of the yield curve. So if you adjust for risk-adjusted return, you'll actually see that the average long short-fund has done better than the longer-dated Treasury since the market started to rally at the beginning of 2009.

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