Our Picks for Alternatives and Other Diversifiers

Note: This article is part of Morningstar's December 2014 Guide to Better Investment Picking special report. 

Stocks, bonds, and conventional mutual funds and ETFs provide all the variety some investors need when it comes to building a diversified portfolio. But for those looking for added diversification, or for funds that take alternative approaches to investing in stocks, other fund types may warrant a look. These may include funds investing in traditional diversifiers, such as gold and real estate, and/or funds that use hedge-fund-like strategies.

This is a particularly apropos time to discuss the topic of alternative funds and diversifiers. With the current bull market now in its sixth year and stocks appearing to be slightly overvalued (based on Morningstar analysts' estimates), and with interest rates poised to rise, neither stocks nor bonds look particularly attractive right now. Plus, with the 2008 market swan dive still on many investors' minds, some are seeking out funds designed to mitigate the potential damage of a repeat performance.

That isn't to say that your portfolio is incomplete without these diversifying asset classes or strategies. Many investors are perfectly content holding only stocks and bonds in whatever allocation works for them. But for those interested in exploring other approaches designed to behave differently than their traditional stock and bond holdings, the following analyst-approved funds are a good place to start.

Alternative Funds
Alternative funds, which use hedge-fund-like investment strategies, encompass a wide variety of different approaches designed to provide exposure to stocks in nontraditional ways. For example, there are alternative funds designed to provide protection against bear markets and others in which managers routinely hold both long positions in stocks they expect to appreciate in value as well as short positions in those they expect to lose value. Morningstar analysts like  this list of alternative funds (Premium Membership required), and the funds below are two examples from it.

 Gateway (GATEX): This fund attempts to earn a better risk-adjusted return than the S&P 500 by selling index calls to collect income and buying index puts for downside protection. While the fund's long-term track record is solid, the fund has not delivered market-beating returns after fees (relative to the S&P 500) for the past five years. However, it still compares favorably against long-short equity peers, and many investors will find its strategy--which cuts off extremes on the upside and downside--useful as an equity alternative. (This fund may charge a sales load.)

 Merger (MERFX): This fund invests at least 80% of assets in merger-arbitrage-related investments, buying the stock of an acquisition target and shorting the acquiring firm's stock. With the help of four other investment professionals, managers Roy Behren and Michael Shannon consider all merger and acquisition opportunities available in the marketplace. The team will research the strategic rationale behind the deal and analyze financial, legal, and regulatory obstacles to completion. Like other merger-arbitrage funds, this fund delivers low returns that are uncorrelated to the S&P 500 and the Barclays U.S. Aggregate Bond Index, with 10-year correlations of 0.56 and 0.19, respectively (as of April 17).

Commodities
Despite being one of the worst performing of all fund categories of late--down more than 12% so far this year and down 3% per year, on average, over the past five years--a commodities broad-basket fund can be a useful inflation hedge and portfolio diversifier.  This list shows our analysts' picks in this area and includes the following.

 PIMCO CommoditiesPLUS Strategy (PCLAX): This fund, too, invests in a basket of derivatives to replicate a diversified commodity index. It tracks the Credit Suisse Commodity Benchmark Index, which covers 30 commodities (roughly 55% energy, 13% industrial metals, 8% precious metals, 20% agriculture, and 4% livestock as of October 2014). Manager Nicholas Johnson then takes long and short active positions (generally 15-45 basis points each) in an attempt to moderately outpace the index, targeting an annual tracking error of 2%-3%.
ETF alternative:  GreenHaven Continuous Commodity ETF

Gold
Despite controversy among investors regarding its intrinsic worth, gold has long been a traditional portfolio diversifier and inflation hedge. For investors who'd prefer not to take physical possession of the precious metal, one way to gain exposure is by investing in gold-mining stocks, as discussed here. There also are several ETFs that offer ways to own gold more directly, including the following, an analyst favorite.

iShares Gold Trust (IAU): A near-ideal combination of low expenses, high liquidity, and institutional stability. The fund is a "pass-through" vehicle for physical-gold ownership, with each share worth about a hundredth of an ounce of gold. The fund--technically, a trust--is sponsored by iShares Delaware Trust Sponsor LLC, an indirect subsidiary of BlackRock; but the day-to-day management is conducted by the trustee, BNY Mellon.
Alternative: SPDR Gold Shares (GLD)

Real Estate
Real estate has long been seen as a classic portfolio-diversification tool. And even though real estate investment trusts, or REITs (companies that manage commercial properties and collect rent), have become more correlated to stocks in recent years, they still provide diversification benefits and an inflation hedge, not to mention a good source of investment income. For a list of our analysts' favorite real estate funds, click here. It includes the following.

 T. Rowe Price Real Estate (TRREX): Manager David Lee looks for REITs that have good growth prospects and are trading at a discount to their net asset value. Lee's patience shows in the fund's five-year average of 10% annual turnover, well below the category norm during that time period. In addition to a cheap price tag, Lee looks for REITs run by managers with a proven track record of allocating capital.

 Vanguard REIT Index (VGSIX): This fund is one of the cheapest ways for investors to gain broad-market cap-weighted exposure to real estate investment trusts (expense ratio: 0.24%). The fund seeks to replicate the performance of its benchmark, the MSCI US REIT Index, as closely as possible. The index includes all domestic REITs from the MSCI US Investable Market 2500 Index, excluding mortgage REITs and non-real-estate specialty REITs (timber, prisons).
ETF alternatives:  Vanguard REIT ETF (VNQ), Schwab US REIT ETF (SCHH)