Alternatives Worth A Look, As Fear Clouds Markets

As the government warns Americans that a major terrorist attack could hit the U.S this summer, fear hangs heavy over the stock and bond markets. Some smart investors are focusing more on so-called alternative investments-commodities, real estate, and hedge funds, among others.

They're called alternatives because they behave differently from traditional stock and bond investments. For example, when inflation picks up, stocks and bonds tend to fare poorly, but real estate and commodities do well. There is no assurance that alternatives will do well in the event of a major terrorist attack, but they do provide a way of diversifying beyond traditional securities and that could provide a portfolio buffer.

Bill Gross, who manages the huge PIMCO Total Return bond fund and has built a reputation over the past two decades as the smartest of bond investors, announced in January that he was pulling his own money out of Total Return and putting it into commodities, leveraged municipal bond funds, and inflation-protected securities. Other prominent investors are moving in a similar direction. "We've talked for years about the need to diversify out of stocks and bonds to alternatives," said Ben Inker, director of asset allocation at Grantham Mayo Van Otterloo, a Boston-based firm managing $60 billion. "Today, we have become more strident about it."

Inker and others believe stocks aren't likely to provide good returns during the next five years. Meanwhile, bonds will suffer as the economy continues to pick up and interest rates rise. In this environment, alternative investments could have a lot to offer.

Institutional investors and very wealthy individuals have long turned to alternatives for their diversification benefits. By behaving differently than stocks and bonds, alternative investments can reduce the overall volatility of a portfolio, thus increasing your long-term returns.

From 1972 through 2003, for example, U.S. stocks generated an 11.4% compound annual return-almost exactly the same as the 11.5% annual gain of the Goldman Sachs Commodity Index. Yet a portfolio split evenly between the two kinds of assets and rebalanced annually did even better, returning 12.8%. That's possible because of the different ways stocks and commodities respond to economic cycles. The tendency for one to be up when the other is down helps a 50/50 portfolio avoid big swings in either direction, and that can improve performance.

Moderating volatility will also make it less likely that you will succumb to the emotion of a plunge in stocks by selling into a bear market. If your portfolio loss in stocks is softened by a smaller loss or a gain in an alternative investment, it makes it easier to stay the course and stick with your long-term stock investments.

Yet as appealing as alternative investments may be, getting access to them can be difficult. Hedge funds, direct investments in oil and gas exploration and real estate may require large commitments, and are illiquid. Until recently, if you didn't have millions of dollars you could tie up for five or 10 years, most alternatives remained off-limits.

Within the past few years, though, new mutual funds and other fund-like investments have made alternatives more accessible. Real estate investment trusts (REITs), in particular, have done a good job providing exposure to a healthy real estate market at a time when stocks were struggling. From March 2000 through March 2004, REITs soared 124%, while the Standard & Poor's 500 stock index declined 20%. Meanwhile, funds have been created to track the Goldman Sachs Commodities Index-which posted a 59% gain during the same period- and the Dow Jones AIG Commodities Index. It didn't take a large commitment to commodities or real estate securities for these two asset classes to have done real damage control, and there was a big payoff in this bad period for stocks for diversifying into these alternative asset classes.

Hedge funds, too, have become easier to tap, thanks to a whole raft of registered funds of hedge funds established during the past two years. These funds of funds diversify by investing in as many as three dozen hedge funds, and, unlike the underlying hedge funds, the funds of funds are registered with the Securities and Exchange Commission. Investment minimums, typically from $250,000 to $1 million for a hedge fund or fund of funds, may be as low as $25,000 for these new vehicles.

Still, these options have drawbacks, including very short track records and extra layers of fees. When you invest in a fund of hedge funds, for example, you pay fees not only to the hedge funds' managers but also to the manager of the fund of funds. Moreover, commodities and hedge funds can be very volatile, and after four years of outstanding returns, REITS could be due for a time out. Past performance in no way guarantees a good result in the future. So even if you decide to invest in alternatives, you may want to limit them to 20% of your portfolio.

It's wise to carefully examine special risks associated with an alternative investment to ensure it is consistent with your financial needs and risk profile.

8/05/2004 © AdvisorSites, Inc. 2001. All Rights Reserved.