The Past Decade’s Best Alternative Investments

The (Relatively) Brighter Side It has been 10 years since alternative investments burst onto the scene. In 2009, after the financial crash, they were the mutual fund story, gathering much of the industry's headlines. Hundreds of alternatives funds were launched over the next several years. Exchange-traded funds followed suit, with offerings that ranged from staid to highly speculative.

The timing was poor; with one notable exception (more on that later), equities have since pounded all rivals. For stock-heavy investors, alternative investments have come in two flavors: 1) mostly useless and 2) thoroughly useless.

Tuesday’s column discussed the thoroughly useless alternative-fund categories. Today’s will cover the mostly useless. This is meant as a description of the past, not a prediction. Few alternative funds proved useful during a decade of stock market triumphs, but they might prove so over the next 10 years. Things change.

As with Tuesday’s column, each alternative investment will be listed by its Morningstar Category, along with its annualized rate of 10-year return, from the years 2009 through 2018. Also provided will be the number of times that the category average exceeded the S&P 500’s result during the three calendar years when stocks faltered: 2011, 2015, and 2108. The index barely broke even during the first two of those years and lost 4.4% during the third.

5) Precious Metals Annualized returns: 3.9%, negative 3.4%; 0 for 3 against the S&P 500 There are two varieties of precious-metals funds. One consists of ETFs, which indirectly hold bullion--mostly gold--through futures contracts. Morningstar categorizes those funds as being commodities precious metals. That category gained an annualized 3.9% for the decade. The other group of precious-metals funds contains traditional, actively managed mutual funds that invest in mining stocks. Those funds, labeled equity precious metals, lost an annualized 3.4%.

Precious metals scraped into this column, rather than onto the thoroughly useless list, because the ETF category turned a profit. That was enough to place precious metals ahead of Tuesday’s funds, which couldn’t figure out how to make any money at all. That doesn’t mean that precious-metals funds were much good. After blazing to a fine 2009-10 start, they frittered through the next eight years, including losses in all three years when stocks (relatively speaking) struggled.

The problem, if it can be called one, was the absence of inflation. When inflation is dormant, precious-metals prices tend to respond to industrial demand, which means that their funds aren’t particularly alternative. They require inflation to demonstrate their merits by diverging from the crowd. Should that event occur, precious metals will likely thrive once again. They are a reasonable, albeit highly volatile, complement to inflation-protected bonds.

4) Nontraditional Bond Annualized return: 2.9%; 1 for 3 against the S&P 500 As with so many other alternative investments, nontraditional bond funds were developed to combat inflation. (All those dire 2010 predictions!) Traditional bond funds have positive durations, always, meaning that they can't avoid losses when interest rates rise. Nontraditional bond funds attempt to be craftier. When interest rates are heading north, they can reduce their durations, in some cases even below zero (meaning that they directly profit from interest-rate increases.)

Or so the theory goes. In reality, it’s very difficult to time interest-rate movements and quite easy to be “nontraditional” by owning credit-sensitive securities instead of Treasuries. Which is what most funds in the category have done. They have behaved rather like high-yield bond funds, profiting in most years but struggling, as do all credit-sensitive securities, when the stock market falters. The category lost money in 2011, again in 2015, and once again in 2018 (although it did outdo the S&P 500).

Meaning that it wasn’t much of an alternative. In truth, I don’t regard nontraditional bond funds as alternative investments, not in the sense of diversifying a balanced portfolio. Most are solid investments, which is why they qualified for today’s column, but they should be thought of as bond funds, not as alternatives.

3) Multialternative Annualized return: 2.5%; 1 for 3 against the S&P 500 Multialternative funds, which invest in several alternative strategies (you probably guessed that from the name), gained slightly less over the decade than did nontraditional bond funds and fared similarly during the test years of 2011, 2015, and 2018. Multialternatives, too, lost money on each of the three occasions but did stay slightly ahead of the stock market index in 2018.

The problem for multialternatives was the same as with nontraditional bond funds: too much equity exposure. Although alternative strategies strive to be uncorrelated with stock performance--or better yet, negatively correlated--most cannot completely escape the connection. As with stocks, most alternative strategies benefit from a healthy global economy. Thus, multialternatives are unreliable stock market diversifiers.

They do, however, carry the potential to behave somewhat less conventionally than the nontraditional bond fund category, which is why I have placed them one notch higher on this column’s list.

2) Cash Annualized return: 0.5%; 1 for 3 against the S&P 500 By cash, I mean Treasury bills (the source of the above calculation) or something of similarly high quality. "Cash substitutes" that assume credit and liquidity risk so as to earn extra yield aren't viable alternatives because, when stocks plummet and the alternative is required, it doesn't show up. Many such cash substitutes suffered double-digit losses in 2008.

The pleasant aspect of cash is that its nominal returns are almost always positive. The unpleasant aspect is that they often are very low, such that cash lagged the S&P 500 in 2011 and 2015, even though the index gained only a couple of percentage points those years. Cash isn't much of a long-term investment unless things head really south. On the other hand, in such a dire scenario, cash is one of the few alternative investments that can absolutely, positively be relied upon.

Which places it high up today’s list, despite its sloth. Also, it is worth noting, its seemingly poor 0.5% annualized rate of return from 2009-18 placed it ahead of every alternative-investment category in Tuesday’s bottom-performers column.

1) Inflation-Protected Bonds Annualized return: 3.0%; 1 for 3 against the S&P 500 Inflation-protected bonds sometimes act strangely. Because their prices are affected more by expectations of future inflation than by current reports and because they have fairly long durations, inflation-adjusted bonds can surprise. Who was to know that they would gain almost 11% in 2011 and then decline by 8% two years later, when inflation rates and conventional-bond performances remained pretty much constant?

Thus, they lack cash’s dependability. They compensate for that deficiency--and more, in my view--by having superior total returns, while retaining cash’s main protections. Most funds in the inflation-protected bond category are Treasury-heavy, meaning that their holdings not only guard against inflation (duh), as do most alternatives, but also perform well during flights to safety. Of all security types, inflation-protected bonds offer the highest chance of recording a real, postinflation profit over the next 10 years.

That makes it this column’s alternative-investments winner.

Outside the Box Finally, there's that notable exception that I mentioned at this column's beginning: cryptocurrencies. Bitcoin made more money than, well, anything from its 2010 inception through December 2016. Since then, it has lost 80% of its value. Whether that makes it the best or worst of alternative investments depends upon one's purchase date. I suppose that it would be fair to say that bitcoin wins both awards. It delivered the best of times, and then it delivered the worst of times.

Cryptocurrencies certainly deserve consideration as alternative investments. They may very well be sound choices. However, they lie outside this column’s scope, in part because your author knows little about them and in part because, due to the SEC’s reluctance, cryptocurrencies cannot be held by retail funds.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.