What Role Do Alternatives Play in a Portfolio?

Are alternatives a must-have for a properly diversified portfolio, or overpriced and overhyped?

Morningstar.com readers have a broad range of opinions on this question, based on their responses to my query in the Alternative Investments forum on the site. Some Discuss forum participants argued that the alternative products available to retail investors don't offer much that you can't get by building a well-diversified portfolio of conventional stocks and bonds. Others, meanwhile, think that alternatives have the potential to improve their portfolios' risk/reward profiles.

But which alternatives are best, and just what is an alternative, anyway? To read the complete thread or voice your own opinion on the worthiness of alternatives, click here.

'They Do Not Have a Magic Bullet'
As the thread clearly illustrates, there's little consensus on what constitutes an alternative. Poster tedraab opined: "[The term] is so broad as to be almost meaningless." Some posters interpret the term narrowly, to include only those investments that use shorting or hedging strategies. (That's how Morningstar's alternative investment strategist Nadia Papagiannis defined an alternative in this video.) Others employ the term more expansively to encompass real estate, hard assets, as well as private investments in businesses and real estate. FidlStix helpfully offered: "Wikipedia defines 'alternative investment' as 'an investment product other than the traditional investments of stocks, bonds, cash, or property.'"

Sagebobk is one investor who has embraced the former type of alternative--those that use hedging strategies in an attempt to reduce risk and diversify a portfolio composed of stocks and bonds: "I have been using alternative strategy funds for about 10 years and have added both the number of funds and percentage allocation to this category over time. I want to reduce volatility in my portfolio but still try to earn a reasonable return over time." Among the funds he has used are Merger Fund (MERFX), Gateway Fund (GATEX), and AQR Managed Futures (AQMNX). But Sagebobk's experience hasn't been universally positive. He wrote, "I've also owned Highbridge Statistical Market Neutral and Diamond Hill Long-Short Fund (DIAMX) but have sold both due to poor performance."

TOOOINTENSE argued in favor of employing shorts as part of a portfolio. "Shorting is the best alternative vehicle in my opinion ... (I prefer to call it a strategy). I have done far better shorting than all the alternatives except energy."

Sylvie has been tiptoeing into hedgelike vehicles and strategies, including writing covered calls and shorting. Sylvie has found some success with the short positions, including a position in ProShares UltraShort MidCap 400 (MZZ), but also acknowledged that shorts don't always work out the way you've planned. "The last alternative I've tried recently is iPath US Treasury Long Bond Bear ETN .... I bought a good-sized chunk, intending it as a long-term hold. It went down around 35%-40% soon thereafter. I didn't really understand why, so I realized I didn't understand it well enough. Then it went up a bit, and I sold 2/3 of it. I didn't understand why it went up, either. I thought it was going to be pretty straightforward, but I suppose my timing was wrong."

Another contingent of posters, meanwhile, is skeptical that hedgelike vehicles are a necessary ingredient for most portfolios. Earlyride summed up the naysayers' case against such investments: "It is difficult for me as a retail investor to find and invest in well-managed private equity and hedge funds that will provide both alpha, and help diversify my core public equity and bond holding. ... Tax, liquidity, and transparency issues ... come with these investments."

Mwleach has also been underwhelmed by the hedgelike vehicles available to retail investors. "The long-short category had some appeal to me, but I never found a long-short mutual fund I felt was worthwhile." Mwleach went on to note that while retail hedgelike funds have lower costs than the usual "2 and 20" (2% expense ratio/20% of profits) cost structure that hedge funds employ, retail products' often-high costs are a potential impediment for them, too.

Chang concurred that expenses are an obstacle for retail funds that use hedgelike strategies. "I added an arbitrage/merger fund, AQR Diversified Arbitrage (ADAIX), about a year ago, when it appeared both stocks and bonds faced headwinds. It's gone absolutely nowhere, but I'm willing to give a fund like this a solid three years. ... Unfortunately, all merger and arbitrage funds tend to be a little expensive (Merger, Arbitrage (ARBFX)), which is a headwind in itself."

Meanwhile, mwleach noted that even accredited investors who are eligible to buy true hedge funds may be shut out of the best options. "[T]he total amount I would be willing to commit to one or more hedge funds is likely insufficient to get me into the 'best' ones. I have investigated a couple of these over the years, but I just never could get too excited. The illiquidity, lack of transparency, and high cost, taken together, represented too much of a drawback IMHO. Since Morningstar has started providing some information on hedge funds, I have monitored them enough to convince myself that they do not have a 'magic bullet'--or, if a few of them do, it will be extremely unlikely I would be able to identify them in advance."

‘There's Only So Much Oil in the Ground’
Several other posters noted that they put commodities, metals, and other hard assets under the alternatives umbrella.

Matthew9 laid out the bull case for commodities (at the right price), "I've been adding commodity investments for some time when prices become attractive. There's only so much oil in the ground and many metals will likely be approaching their extraction limit in the next two decades."

Yet other posters noted that the existing vehicles available for investing in commodities--particularly the futures-based ETNs and ETFs--are flawed.

Zorkl55 shared the following experience: "Commodities have proven problematic for me. I owned two funds… [but] I eventually withdrew from these, with a modest gain in each, due to both the contango effect, which erodes monthly gains significantly, and due to the short-term and intermediate-term picture for commodities. Long term, I still think commodities are a great play: figuring out which asset classes are best for participation in commodities has proven challenging."

Other posters in the thread noted that they have attempted to be more surgical, focusing on specific hard assets in which to invest.

Reti59 has opted for a broad basket of precious metals stocks via ETFS Physical PM Basket Shares (GLTR), which holds physical gold, silver, platinum, and palladium bullion.

Gaiuslives' first alternative was gold bullion: "I built a 4% or so position (at cost) to my portfolio in the first few years after 9-11, when I became concerned about waging wars on the national credit card. That position has remained largely intact (I sold about 15% of my position in late 2010) and has been enormously profitable, and a wonderful diversifier. I have no plans to either add or reduce this position for the foreseeable future. That said, in the wake of the 2008 crisis, and in light of lingering risks of Euro debt (and other) sovereign debt concerns, bullion's unique attribute of having no counterparty risk tempts me to add to it....”

Hershey, meanwhile, is downright bullish on the stocks of gold and gold-mining firms, holding the gold bullion ETF SPDR Gold Shares (GLD) as well as Market Vectors Junior Gold Miners ETF (GDXJ) and two individual miners, U.S. Gold Corporation (UXG) and Rubicon Minerals .

Dragonpat, however, has recently decreased a position in gold in favor of an ETF that invests in companies that produce rare earths. "I have started investing in rare earths (Market Vectors Rare Earth (REMX), an ETF), because all of the devices like computers, cell phones, and even high-grade weapons contain them. I think that China will be hard-pressed to supply their own future needs of these materials ..."

Yet another contingent of users is keen on income-producing natural resources securities, with master limited partnerships and timberland receiving repeat mentions. Gaiuslives is in the process of building out exposure to these types of securities: "I earmark about 10% of my portfolio to distribution-paying equity in 'hard assets,' which includes exposure to energy, agriculture, and timber. My 10% earmark is not fully in place yet. I plan to add to it on any further price weakness in those areas going forward."

Sweetbread is also employing timberland and MLPs, among other alternatives, to fill out the "other" role in the portfolio. Yet shipmad notes that even sensible investments like MLPs can be a bad idea if you buy them when they're expensive. "I would like to add MLPs, but I missed the good buying opportunities. I'm not interested in them (or any equity) trading near yearly highs."

‘A Sense of Security’
Foreign currency, global bond, and real estate investments also received repeat mentions as viable alternative options.

Juris2 is enthused about TIAA Real Estate Account for the alternative slot in a portfolio. "[The fund] focuses on direct ownership of commercial real estate. It's not a REIT. While over longer time spans, TREA's performance is correlated with the performance of the economy as a whole (it crashed in the Great Recession of 2008-09, for example), it typically has low volatility over short- and medium-term, and it has its own distinct movements and momentum. There's also a psychic gain from this investment. Both the nature of the instrument (direct ownership of property) and the object of investment (commercial real estate) provide me with a sense of security that I don't get from my other investments." (The TIAA Real Estate Account received a positive endorsement from several other users, too; however, it's only available to those who have access to TIAA-CREF-managed retirement plans.)

Gaiuslives uses foreign bonds alongside other alternatives. "I have built a position in [non-U.S. bonds] commencing in 2006. The vehicles of choice that I use are actively managed, index-agnostic, and tend to make both long- and short-currency bets."

Other posters have looked beyond the universe of publicly traded/publicly listed investments for their alternatives. Richendric wrote, "Our truly 'alternative' investments are really our 'family' investments as any proceeds will go to our heirs. We now have positions in two rental properties and three direct investments in natural gas and oil drilling ventures in Pennsylvania."

All of the Above
Rather than casting their lots with a single type of alternative investment, several posters noted that they'd assembled a broad basket of investments that they believe have strong diversification characteristics.

Sofarsogood is one such poster, writing, "I broadened my holdings starting about 10 years ago to include an assortment of 'alternative investments' in pursuit of both return and reduced correlation. It worked well in most environments except the Great Meltdown when most non-fixed-income investments' correlations increased. With an emphasis on energy/hard assets, the strategy should work well in more robust times and offer better protection with a weak dollar, but could be hammered in a deflationary environment."

JHAsheville has also embraced a diverse pool of alternatives, using them to augment a portfolio of traditional stock and bond assets. "[We hold] a dash of commodities, precious metals, inflation-protected securities, a health-care fund and emerging markets. Add a little squirt of hard core real estate; residential lot (holding a 5 year note on) and a second home. So far so good!"

Tradinggoddess2's list of alternatives was one of the longest of any poster's and includes emerging-market bond funds, REITS, commodity equities, fertilizer, MLPs, local currency bonds, real estate (TIAA Real Estate again), and precious metals. The reasoning: "I started all this in about 2004 in earnest after learning the lesson of not being overweighted in any one sector--i.e., tech."

For those attempting to build a diversified portfolio of alternatives, several posters recommended Permanent Portfolio (PRPFX), a mutual fund that delves into metals and currency investments as well as more conventional holdings.

Cpwcpw wrote, "As I don't like to play with individual stocks, let alone 'alternatives,' I use an interesting little mutual fund called the Permanent Portfolio. It invests in gold, silver, Swiss francs, timber, real estate, and some more conventional stuff. Fairly low expenses, wallops the S&P, been 5 stars since time began. My account executive had never heard of it; now he's sold."

Mwleach's go-to fund with an alternative feel is PIMCO All-Asset All-Authority (PAUIX). "Rob Arnott appears to be doing a good job there, and being able to invest in a wide range of asset classes, this fund probably qualifies as an 'alternative'--one with a good record and reasonable expenses. I invested 10% of our permanent portfolio in this fund over a year ago, and so far so good."

Naysayers
As bullish as some posters were, others aren't convinced of the need to venture heavily--or at all--into alternatives.

Oleyeller, for example, notes that there's no free lunch. "It isn't clear to me that investors are better off with alternatives. I would need more history. If they reduce risk, then I expect return would also suffer. Also, they work best with longer-term horizon investors where correlations can play out. Most older wealthy clients want simple capital preservation investments that they can understand."

FidlStix is also emphasizing plain-vanilla stocks and bonds: "I plan to keep 90%+ of my portfolio in the tried and (I hope still) true--stocks, bonds, and funds holding these vehicles."

Duanej argued that investors haven't needed to look beyond equities, at least not lately. "I don't own anything that could be considered an alternative investment. In my estimation, there have been plenty of buying opportunities in the equity markets in recent years, and I don't feel the need to look elsewhere."

Finally, cgkerns offered a bit of advice that fits no matter what you're investing in: "As always, if you don't understand it, don't invest in it."

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