Credit: Shutterstock photoUsing alternative investments, beyond the usual stalwarts of stocks and bonds, is a good way to diversify. Not foolproof, mind you. They can disappoint you big-time. Here's a guide to figure out their pros and cons.
Overinflated, bubble, imminent crash: Not words you want to hear when your money's mostly in Wall Street stocks and bonds. If you look to diversify without sacrificing returns, the good news is that you literally do have alternatives.
Alternative investments are traditionally defined as products other than standard vehicles such as stocks, bonds or cash. There are a lot of them, each with their own characteristics.
Common examples include precious metals such as gold or silver , artwork, antiques, coins and stamps. They can also include such financial instruments as hedge funds; unconstrained fixed income bond funds covering many market sectors; macro-strategy funds to control risk; commodities and managed futures; real estate ; and long/short equity that uses timing to maximize assets' returns.
Other examples: convertible arbitrage ; private equity; vulture funds of distressed investments such as bankruptcies; venture funds targeting startups, young companies and similar projects; and merger arbitrage , or buying stock of both companies involved in a deal to combine.
These investments also come in the familiar hedge-fund format and in many cases as mutual funds, exchange-traded funds and as a fund of funds.
As traditional asset classes rose in price over the past six years, so did valuations , the determining of the current worth of an asset or company. Factors involved in determining a stock's value can include the company's management, capital structure, outlook for future earnings and current market value of assets.
Debate rages over whether the stock market is overvalued. As you watch the potential Wall Street bubble rise, alternative investments can offer you diversification when other assets' prices overheat.
These investments can help increase return and lower risk, often in bad market times; institutional investors often use alternatives to grow pension and endowment funds. Alternatives managers can profit from both rising and falling markets - generally not true for managers who invest solely in traditional assets.
Over the past few years, alternatives' returns were lower than their historical average. After doing well during 2008 and 2009, alternatives took a back seat to both the stock and bond markets in recent years when asset classes like real estate , oil and gold suffered.
Then, around the middle of 2014, something changed regarding global investors' appetite for risk; alternative investments began to once again perform well in both absolute terms and against other classes of holdings.
(To learn more about this shift, read our recent article, " When Securities Diverge .")
In 2011 to 2013, global central bank monetary policies (aka money printing) also began mimicking the long-established Federal Reserve's quantitative easing (QE), the buying of bonds to stimulate lending and economic activity via depressed interest rates. QE muted many of the historical swings from which alternative managers benefited.
Those same central bank policies that dampened performance in previous years now looms large in much of the price movement that alternatives managers benefit from today.
The recent lack of rapid stock price movements, or volatility, also figures in alternatives' appeal in the future. We measure volatility with a Standard & Poor's index called VIX . When this index is high, investors are fearful signaling that we are closer to a near-term market bottom.
When low, the VIX signals that investors are confident - or complacent, which indicates we are probably closer to a market top. In calm times, the VIX dips as low as 10; in steep market dives, it shoots to around 25. Right now it hovers around 18.
(I also recently wrote about increased market volatility , if you want to learn more.)
How did these investments do recently compared with the overall market? Below you can see the performance of a number of alternative managers we work with.
Year-to-Date: Ending 1Q15
12-Month Trailing: Ending 1Q15
Are we headed into - perhaps already in - the perfect environment for these holdings? Maybe not perfect, but the current environment does seem to reward the astute alternatives manager in the wake of such recent trends as declines in oil and lumber prices and the continuing strength of the U.S. dollar against foreign currencies . Not to mention, again, ongoing global monetary policies and alternatives' positive performance during the crashes of 2000 and 2008.
These investments may require extra research and due diligence - especially the latter, the U.S. Securities and Exchange Commission warned last year - but you can't ask for a much better tool for diversification.
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David Gratke is chief executive officer of Gratke Wealth LLC in Beaverton, Ore.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
