Investors seeking more diversification or a different kind of bet can choose alternative investments — things like long-short bets on credit products, or managed futures contracts.
If things followed the usual pattern, ordinary folk would gradually find easier ways to get at these more remote recesses of the investing world through professionally managed funds. But these offerings have developed only slowly and sport some red flags, such as high fees.
“Alternative investments mean different things to different investors,” says David Twibell, president of Englewood, Colorado-based Custom Portfolio Group.
“For some, alternative investments are simply a catch-all category for things that don’t fall into the more traditional asset classes. These can be anything from gold to hedge funds, and everything in between,” he says. “For other investors, alternatives are limited to certain investments that either have no historical correlation to other markets, or aren’t available in a publicly-traded vehicle.”
[See: 7 of the Best Stocks to Buy for 2018.]
Sophisticated investors can buy into options like hedge funds directly, but small investors accustomed to funds have fewer options.
Still, it can be worth seeking them out if the investor really feels they might round out a portfolio, says Adam Taback, head of global alternative investments at the Wells Fargo Investment Institute.
“By incorporating them alongside equity, fixed income and real assets, alternative investments act as a fourth asset group and can help to smooth the volatility of a portfolio and unlock return streams different and distinct from the other asset groups, Taback says.
Not all experts agree these investments are suitable for a wide range of small investors, but Kevin Mirabile, clinical assistant professor in finance and business economics at Fordham University in New York, says they’re worth a look.
“Yes, alternative investments are for everyone,” he says. “In the past only qualifying institutions and high-net-worth individuals could access the world of hedge funds, private equity and other alternative investment products. Today, there are plenty of ways for the average investor to access these products using a brokerage account, mutual fund, ETF, IRA or 401(k) plan.”
Every investor benefits from diversifying, and diversification using investments with low correlation is “the best sort of diversification,” Mirabile says.
“Think of it this way, you get to keep the return from an alternative allocation while lowering your risk,” he says. “So even if a hedge fund delivers 85 percent of the return of the S&P 500 you can be better off if the correlation is low and your portfolio risk drops by 25 percent.”
The alt-investment world offers actively managed funds, and some that attempt to mimic index funds, typically by constructing an index of their own. But pickings are slim in exchange-traded funds, which have become the first choice for many small investors in recent years.
Though many lists of alternative ETFs include leveraged ETFs, which use borrowed money to amplify results, these funds really should not be included because they march in step with the markets, while true alternative investments do not, Morningstar says.
The largest alt ETF by assets is IQ Hedge Multi-Strategy Tracker ETF (ticker: QAI), according to ETFdb.com website. It invests in a wide array of hedge funds and has a 0.76 percent annual expense ratio (or $76 per $10,000 invested), which is high for an ETF. Annual returns have averaged 2.5 percent over the past five years.
[See: 7 ETFs for a Solid Portfolio Defense.]
If that sounds weak next to the broad stock indexes, remember alternative investments are not supposed to match mainstream holdings like stocks, they’re supposed to be “uncorrelated,” zagging while others zig.
Investors will find more options among actively managed funds because of the careful picking and choosing required.
The big player among alt funds is AQR capital management, and its premier fund in this category is AQR Long-Short Equity Fund ( QLEIX), a managed mutual fund which seeks to profit from both rising and falling stocks. Since that takes a lot of work and active trading, it carries a nearly 1.4 percent expense ratio, extremely high compared to index funds and plain vanilla ETFs that often charge less than 0.1 percent. The fund’s nearly 14 percent gain in 2017 trailed the Standard & Poor’s 500 index performance of near 22 percent, but QLEIX crushed the index the previous two years.
To invest, you must start with a minimum of $100,000 for an IRA or an R6 “clean share” class for a taxable account. Clean shares are designed to avoid conflict of interests found in funds that pay advisors who recommend them.
Alt investments is such a loose term it’s hard to say which investors they suit, Twibell says.
“If you want something with an inverse market correlation … a mutual fund that focuses on shorting stocks might make sense,” he says. “But if you simply want something that can perform well regardless of what happens in the overall markets — something that is completely uncorrelated to markets — currencies might be better.”
Michael Tanney, co-founder of Wanderlust Wealth in New York, warns investors accustomed to moving money around easily to be wary of alt investments of any kind.
“We have purposely kept our clients away from alternatives because of the lack of liquidity, long hold periods, and high-performance hurdles after fees,” he says.
Mirabile, however, is more enthusiastic, so long as the investor is careful.
“The key to alternative investing is not to pay away all the performance in fees,” he says. “Investors need to look carefully to make sure they are getting solid performance, low fees and low correlation” with other assets, such as stocks.
[See: 7 ETFs to Trade Like a Hedge Fund.]
“Long and short equity funds are a great example. They can deliver 80 percent of stock market performance with less than half the risk and low correlation,” Mirabile says. “The same is true for many fixed income relative value funds. Retail investors should stay away from highly leveraged funds and those that cannot be redeemed daily or weekly.”
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