From the September 01, 2012 issue of Futures Magazine • Subscribe!

The Little Book of Alternative Investments

The Little Book of Alternative Investments:
Reaping Rewards by Daring to be Different
By Ben Stein and Phil DeMuth
John Wiley & Sons, Inc.
$19.95; 257 pages 

Since the big bear market of 2007-2009, which relieved investors’ portfolios of trillions of dollars, there has been an effort to address the fact that a more sophisticated approach than simple diversification should be used to protect against the next big decline. One area that has received considerable attention is alternative investing, which includes typically real estate (not housing), commodities, options, currencies, collectibles, convertible bonds, emerging market debt and private equity. 

Most markets were highly correlated to the market’s overall direction during this bear market. Therefore, it is not surprising that only U.S. Treasury bonds had a positive return.  International stocks, commodities, sectors, market cap domestic stocks and non-Treasury bonds did not fare well.

This book provides a down-to-earth discussion of the possible alternative investments, coupled with the authors’ frank opinions as to which are the best and worst choices. According to the authors, investors need radical diversification, not the standard 60% equity/40% bond portfolio because “…2008 showcased the failure to diversify enough.”

The authors suggest a tilt toward value, small-cap and low-beta stocks. They do favor gold when bought in a basket of other commodities, as well as recommend a small allocation to commodities and REITs. Additionally, Stein and DeMuth provide their rationale for not recommending the following alternative investments: Collectibles, private equity (venture capital and IPOs), buy-write funds, structured products, 130/30 funds and precious metals. The authors mention managed futures that are actively managed by commodity trading advisors, and list the numerous hedging strategies that are used by different funds. 

“Lite” versions of hedge funds are now available to investors in a mutual fund format, but they do not have long-term track records yet. The authors name specific mutual fund hedge funds with their rationale. The appendix contains a list of these alternative investment mutual funds and ETFs that provides a good starting point for those investors interested in these vehicles.

One objective of using alternative investments is to have less correlation between the portfolio components.  Low correlation improves returns with less volatility.  This will result in better risk-adjusted returns. Second, because too many investors are overexposed to one risk factor, namely equity risk, they would be better off spreading out their risk.  Last, cash is the premier alternative investment, but investors seem uninterested in it most of the time.

When using alternative investments, investors need to experience positive returns in most years.  Therefore, they need to research the alternatives thoroughly, and take action so they not only safeguard but grow their principal in market downtrends.

Of the book’s 13 chapters, six are devoted to hedge funds – their basic function, investing approach (e.g., long/short, market neutral and managed futures), fees and performance.  The authors recommend that very high net-worth individuals consider using hedge funds only if they have spent 75-100 hours on due diligence and understand and are able to take the risk.  Other less wealthy individuals can access hedge funds “lite” with the handful of publicly available mutual funds.

Stein and DeMuth provide performance details on 10 basic hedge funds from 1994 through 2010 that include each fund’s mean performance, volatility, correlation to S&P 500 Index and percentage of assets in each of their strategies. Their conclusion is that that all  but one strategy (short bias) would have benefited a stock portfolio since 1994.

Overall, the authors have provided a useful guide to alternative investments for the uninitiated.  This primer is easy to read and understand.  It will help investors determine whether these vehicles should be a portion of their portfolios. Based upon the stock market’s poor performance over the past decade, the smart investor should investigate alternatives to protect principal when the next bear market arrives, as it certainly will.

Leslie N. Masonson is the author of Buy DON’T Hold and All About Market Timing, (Second Edition).  Reach him at lesmasonson@yahoo.com.

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