An Alternative Approach

             SINCE THE STOCK MARKET PEAKED IN October 2007, the bear has been clawing investors. Bonds have delivered scant returns, and naturally, mutual funds holding these traditional investments have fared from so-so to sorrowful.

            Fortunately, investors have options. There are many “alternative investments” from which to choose. “Investors might hold 10% to 25% of their portfolio in alternative investments,” says Peng Chen, president of Ibbotson Associates, a subsidiary of Morningstar.

            Nancy Little, an auditor with General Motors in Detroit, says she wasn’t impressed when her financial adviser initially approached her about shifting some of her assets into alternatives. “After he explained the benefits to me, and I did some research on my own, I understood how holding oil, precious metals, and other commodities could actually reduce my overall risk,” says Little, 57, who is hoping to retire within the next two years. “I put about 25% of my portfolio into alternative investments in early 2007, and they’ve done better than anything else I own.”

            Little owns a commodities fund, a weakening dollar fund, a managed futures position, and gold bullion. Year to date, these investments have returned 14%, close to 1%, -2.5%, and about -1%, respectively. While the investments’ combined performance is less than stellar, it still bested the S&P 500 (down 13%) and international markets, which are down 20%.

            According to Little’s adviser, Ivory Johnson, director of financial planning at The Scarborough Group, an investment advisory firm in Annapolis, Maryland, alternative assets actually reduce a portfolio’s risk. In fact, a portfolio with a 20% allocation in alternative assets from 1998 to 2007 increased average returns by 11.7% and reduced risk, as measured by standard deviation, by 14.6%, when compared with a traditional equities/bonds portfolio. Moreover, Little has a 40-year time horizon, since people are living longer.

            Little is one of millions of investors who are diversifying their portfolio by going outside of the traditional stocks, bonds, and mutual funds and into the worlds of commodities, financial derivatives, hedge funds, and other vehicles. These alternative investments could provide valuable diversification in these tough times–but only if done right and if used in moderation.

 

AGAINST THE GRAIN

            International, emerging markets, and small-company stocks all tended to move in the same direction as large-company U.S. stocks in recent years. However, “Alternative assets are not correlated to stocks or bonds, so they might move up when traditional markets are down. Johnson says.

            According to Chen, alternative investments fall into two broad categories:

            Alternative markets. This category includes asset classes other than stocks, bonds, money markets, and cash equivalents, which are considered traditional investments. Funds holding traditional investments fall into the “traditional” basket while funds holding nontraditional assets are in the alternative markets category.

            With some alternatives, you can get direct access to commodities such as oil and gold. Other asset classes such as currencies and investment real estate may provide welcome relief when mainstream holdings fall from favor. Real estate, for example, wasn’t much help this year but it did bolster portfolios during the last bear market, from 2000 through 2002.

            Astute advisers. This category includes investment vehicles that do not rely upon the success of a particular asset class. Instead, a skilled manager can make money for investors in up, down, or sideways markets. With the market-based alternative assets mentioned above, investment success depends on the price of oil, say, or the demand for investment property. Hedge funds are different–they can make money in any economic environment, depending on how well the fund is managed. “Traditional asset classes such as stocks and bonds do not have the ability to add as much alpha as hedge funds do,” says Chen, referring to the added return a shrewd strategy can generate.

            To illustrate the difference between alternative markets and astute advisers, a commodities index fund will make money if the prices of commodities go up. A hedge fund, though, can make money even if commodities prices go down, as long as the hedge fund manager is smart enough to short commodity futures or hold put options on those futures.

 

CAVEAT EMPTOR

            Just as investing in one stock is risky, investing in one commodity may deliver unwelcome results. The price of oil, for example, plunged from $147 a barrel in July to $115 in August, a 22% drop in less than a month. Some advisers, therefore, prefer to get exposure oil to via a more diversified commodities play. “For some clients, we recommend a small (less than 6%) allocation to iPath Dow Jones-AIG Commodity Index Total Return (DJP),” says Lee Baker, a certified financial planner at Apex Financial Services in Tucker Georgia. “This is an exchange-traded note (ETN) that’s linked to the Dow Jones-AIG Commodity Index, which is diversified among many commodities.” In addition to an exposure of about 33% to oil and gas, this index also tracks the price of soybeans, gold, aluminum, copper, and 11 other commodities.

            Sam Sudame, chief investment officer for Schultz Financial Group in Reno, Nevada, says that his firm prefers PIMCO Commodity Real Return Strategy (PCRIX), a mutual fund for institutional investors that tracks the same diversified commodity index. Since its inception in mid-2002 the PIMCO fund has had one 3% yearly loss, in 2006, and annual returns between 16% and 30% in every other calendar year.

            Chris Cordaro, chief investment officer at Regent Atlantic Capital, a wealth management firm in Chatham, New Jersey, also prefers a diversified approach to commodities investing. His recommended investments include UBS E-TRACS CMCI Total Return (UCI), an ETN designed to track the UBS Bloomberg Constant Maturity Commodity Index of 28 commodity futures contracts, ranging from coffee to zinc.

 

            Going for the gold. The diversified commodities investments listed above hold some gold but the exposure is modest: 7.4% for the Dow-Jones AIG index and 3.8% for the UBS Bloomberg index. If you’d like more gold in your portfolio, one option is SPDR Gold Trust (GLD), which holds gold bullion–nearly $20billion worth. This ETF, which moves up or down with the price of gold, has annualized returns of between 18% and 31% since its inception in late 2004.

            However, “investors in GLD may face a tax problem,” says Sudame. “Any long-term gains will be taxed as high as 28%, the rate for collectibles, not the 15% maximum rate for most investments.” He suggests First Eagle Gold (SGGDX), a mutual fund that invests in mining stocks as well as bullion. This fund has returned more than 19% a year for the last 10 years, through the first half of 2008.

 

Oil’s well. Among commodities, oil may be the most high-profile these days. When prices rose from $60 a barrel in 2007 to $147 in mid-2008, investors with a direct play on oil enjoyed hefty profits. Investing directly in oil has become much easier: In the past few years, several publicly traded investments have been introduced that track oil price movements. They include PowerShares DB Oil (DBO), United States Oil Fund (USO), and iPath GSCI Crude Oil Total Return (OIL).The iPath fund, for example, returned 47% in 2007 and an additional 32% return in the first seven months of 2008.

 

Hedging your bets. Investing in such commodities funds and notes is fairly straightforward: if prices go up, you’ll make money. Hedge funds, on the other hand, are far from simple.

            The classic hedge fund goes “long and short.” That is, the manager buys assets that are expected to appreciate while borrowing assets expected to lose value. The borrowed assets are sold; the manager hopes to buy them in the future at a lower price, use those acquired assets to repay the loan, and thus make a profit on this “short sale.”

            Those types of hedge funds still exist but they’re not alone. Hedge Fund Research Inc., for example, lists 32 different strategies and sub-strategies of hedge funds, such as Event Driven: Merger Arbitrage and Macro: Systematic. The latter, according to HFR President Ken Heinz, are hedge funds that follow trends, using sophisticated quantitative modeling to buy what’s hot

and sell short what’s not. Altogether, hedge fund assets have gone from less than $1 trillion at year-end 2004 to nearly $2 trillion in mid-2008, as investors search for ways to make money in challenging times.

            However, hedge funds might require investments of $500,000 or more, putting them out of the reach of many investors. A possible alternative is to choose a fund of hedge funds, where minimums are lower. “We’ve seen minimum investments as low as $50,000,” says Heinz. Funds of hedge funds offer diversification: Sudame says his firm offers clients a fund of 20 hedge funds, all following different strategies. They can be expensive, though, if you’re paying the fund-of-funds manager as well as the managers of the underlying hedge funds.

            A more practical option, for many people, is to invest in mutual funds using a hedging strategy. “We have been using Hussman Strategic Growth (HSGFX),” says Bill Brennan, founder of Capital Management Group in Washington, D.C. “It holds a portfolio of large-cap U.S. stocks while employing option strategies to earn income and protect against losses. During flat or down markets, this combination may produce superior performance.” As of this writing, this fund was up more than 4% for 2008 while the broad U.S. stock market had dropped nearly 13%.

            Both Sudame and Cordaro recommend TFS Market Neutral (TFSMX), another “long-short” fund. It has returned more than 13% a year for the past three years, far ahead of the major market indexes.

            Investing in alternatives may deliver higher returns in the short term as well as a smoother ride for the long haul. Whatever your investment style, odds are there’s an alternative strategy that will fit your needs. Just keep in mind that while they may add a little spice to your portfolio, they should not be the main course.