Beyond the world of stocks and bonds lies another category of assets: alternative investments. Learn about commodities and other "alt" types that may be available to retail investors.
ETFs and managed futures have helped expand alternative opportunities for individual investors
Democracy as commonly defined is based on government “by the people,” at least in theory and what we remember from high school civics class. We can look at today’s markets through a similar lens, more specifically on the subject of alternative investments and portfolio diversification.
Alternative investments, or “alts,” in some ways represent expanding “democratization” of our markets, where most everyone has a voice or opportunity to vote. Alternative investments take many forms, including commodities, managed futures, hedge funds, private equity and other vehicles that historically were the exclusive realm of sophisticated, deep-pocketed investment professionals. That changed in recent decades as the growth of exchange-traded funds (ETFs) and other, similar assets presented individual investors with opportunities to get a foot in the door of the alternative club.
Ready to dive into alts? Hold on a sec—alternative investments can be a handy tool for portfolio diversification, but compared to traditional stocks and bonds, alts are a different kind of animal, so it’s important for investors to understand how alternatives work. Here are a few key points.
In the 1980s and ’90s, “alternative” became a trendy marketing tag for a certain genre of rock music. But, as definitions, perceptions and tastes shifted, the word grew increasingly squishy, an eye-of-the-beholder term meaning different things to different people. In investing, it’s a good idea to apply similarly critical thinking toward alternative investments. Is this investment truly “alternative,” or more “mainstream?”
Defined broadly, alternative investments reside outside of traditional stocks, bonds and cash. Alts don’t fit neatly into conventional investing categories and may not be available on established exchanges like NASDAQ or NYSE. In addition to commodity futures, managed futures and private equity, other forms of alternative investments include real estate, real estate investment trusts (REITs) and venture capital funds.
When stocks in your portfolio zig, alternative investments zag—or that’s the idea.
In a few words, it’s about correlation, or more precisely, lack of correlation. Alternative investments can be appealing because these assets are supposed to be uncorrelated, or minimally correlated, with stocks and bonds. When stocks in your portfolio zig, alternative investments zag—or that’s the idea.
The potential noncorrelation to stocks is one reason why alternative investments can help diversify your portfolios and add a potential buffer against broader market turmoil. Investors building a diversified portfolio typically aim to have positions as uncorrelated as possible from one another, so everything isn’t moving in the same direction all the time. When one asset class is going down in price, another asset class is going up.
In commodity futures, top alternative categories include energy (such as crude oil and natural gas) industrial and precious metals (copper, gold, silver and others) and agriculture (corn and soybeans, for example). These commodity markets are linked to established, relatively actively-traded futures contracts with a wide following in the financial media.
In addition to buying or selling commodity futures and options contracts outright, there are also managed futures funds, in which a licensed Commodity Trading Advisor oversees a portfolio of futures positions.
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But futures differ from stocks in several ways, and each futures contract has certain fundamentals and intricacies investors should be aware of. Crude oil, for example: Brent crude and West Texas Intermediate (WTI) crude are the global benchmarks, and supply-demand dynamics can differ between the two, meaning prices will not always move in lockstep.
Over the past three decades or so, managed futures have provided a safe port during broader market storms, based on some studies.
During the fourth quarter of 1987, which brought the “Black Monday” market crash, the S&P 500 Total Return Index fell more than 22%. By contrast, the Barclay BTOP 50 Index, which tracks the performance of managed futures funds, rose nearly 17%, according to a 2014 report by futures exchange operator CME Group. During the first quarter of 2009, as the previous year’s credit crisis continued to roil markets, the S&P 500 Total Return Index declined 11%, while the BTOP index fell just 1.8%.
More recently, as U.S. markets repeatedly marched to record highs, managed futures appear to have underperformed major benchmarks. In 2019, the S&P 500 Index gained 29%, while the BTOP index rose 6.7%.
To what extent, if any, that alternative investments are part of a portfolio is largely dependent on an investor’s risk tolerance and time horizon. It’s important to understand that managed futures and other alternative investments should be viewed as a complement to a broader portfolio. Individual investors might consider allocating 5% to 15% of their total portfolio to alts as a ballpark target range.
Investors should approach alternative assets with eyes widen open and make sure they educate themselves on the risks, asset structures and other factors. Alternative investments are often less liquid than stocks and bonds, can be more difficult to value and may come with complex or opaque ownership structures. Some alternative investments, such as hedge funds, may require minimum investment levels that can be higher than other assets.
For hedge funds, these minimums could be in the millions of dollars, though recent years have seen the launch of ETFs and mutual funds that try to mirror the style and tactics of hedge funds, and don’t require as large of an investment.
Managed futures and other futures-related alternatives also pose certain wrinkles. All futures contracts expire, meaning a futures portfolio must be carefully managed over time to “roll” positions from one month to the next to maintain the desired exposure to the commodity. Be mindful that rolling futures positions can amplify or erode returns. For any futures-based ETF, it’s also a good idea to investigate the track record of the fund manager and how they’re addressing their exposure to certain markets.
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