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By Christine Benz | 09-19-2012 10:40 AM

What Is an Alternative Investment?

Alternative seekers should make a distinction between assets that truly have unique economic characteristics and active strategies that purport to generate alpha, says Pinnacle Advisory Group's Michael Kitces.

Christine Benz: Hi, I'm Christine Benz for

The past decade has brought a proliferation of alternative investments. Joining me to discuss the category is Michael Kitces; he is partner and director of research at Pinnacle Advisory Group.

Michael, thank you so much for being here.

Michael Kitces: Thanks. It's great to be here today.

Benz: So, Michael, we've seen this explosion of investments calling themselves alternatives. Let's talk about what, in your view, is the definition of an alternative investment type?

Kitces: So, great question. I take, I guess I'd call it, a relatively simple approach in looking, trying to find what an alternative is and even to define the word alternative, which I think in practice we mean to be an alternative to stocks and bonds, sort of our traditional asset classes.

What I define to be an alternative asset class is something that actually has unique economic characteristics onto itself as an asset class. It's affected in its own manner by economic factors, supply and demand, whatever those sort of underlying metrics are that drive income growth and profitability for that asset class. And so we certainly see that one set of behaviors around what drives everything from supply and demand and economics for stocks. We see a different set of factors for bonds, and so other asset classes would be defined as alternative asset classes if they show their own unique economic characteristics that are separate from stocks and bonds.

Benz: So, let's discuss some of the things that you think are truly alternative, because they do have those unique economic characteristics. I know you'd mentioned commodities.

Kitces: So, certainly, I think, commodities which trade … not only on their own economic basis, but have their own supply and demand factors that, granted, in the shortest run sometimes get overwhelmed by market movements, but certainly in the long run become very material driving factors.

We'd certainly look at real estate as being an alternative asset class onto itself that operates on some of its own economic fundamentals.

So, we do see some separate categories out there that I would absolutely call asset classes. The challenge, I think, is as stock returns and bond returns have become somewhat meager, looking back over the past decade, we're seeing this explosion of anything that is not precisely and only a long-only stock or long-only bond position must be an alternative asset class. The challenge is when we start really looking in detail some of them, they don't really hold up, I think, to that scrutiny of saying, does it really have different economic fundamental supply-demand characteristics, other things that would define it as a unique asset class?

Benz: So, let's talk about some of those categories, some of those investment types that have kind of tucked themselves under the alternative umbrella, but that you don't really think are truly alternatives by the definition that you’ve laid out?

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