In bear markets like this one, it's easy to bury your head in the sand and ignore the damage. Still, there's no time like the present for investors to school themselves on how to fix up a battered portfolio that can emerge stronger when markets finally get back to normal.
Alternative investments, a wide-ranging class of assets that include everything from commodities and annuities to real estate, can be part of that strategy, says Larry Swedroe, a director at Buckingham Asset management and an investment author. His latest book, The Only Guide to Alternative Investments You'll Ever Need, with Jared Kizer, is a guide to picking the best (and avoiding the worst) alternatives to basic stocks and bonds. Here are five of his favorites, with thoughts on how they might fit in your portfolio:
That's right. The bogeyman of this downturn should still—someday—be a viable part of your portfolio. The housing bust makes it easy to shun the sector entirely, but real estate investment trusts, or REITs, historically offer unique risk-management benefits.
Over the past 20 years, REITs have helped juice returns and smooth out volatility. A sample portfolio from 1978 through 2007 shows that putting 10 percent of equity holdings in U.S. REITs improved returns by 0.3 percent and cut volatility by 0.9 percent, compared with investing in stocks alone. Real estate tends not to move in tandem with stocks, and it has almost no correlation with short-term bonds. (The obvious exception to the rule: 2008, when popular indexes like the Vanguard REIT ETF [VNQ] are off more than 40 percent year to date, just like equities.)
Real estate is a "low-correlating asset, not a no-correlating one, but that doesn't mean diversification isn't working," Swedroe says.
A slowing economy and the threat of deflation haunt the market today, but the return-killing specter of inflation will eventually re-emerge, if history is any guide. A small allocation of treasury inflation-protected securities, or TIPS, helps lower the risk of unexpected jumps in prices.
Like other bonds, TIPS offer a fixed rate of return, but returns are adjusted for inflation and can offset losses that can hit stocks when inflation starts to climb. There's a negative correlation between stocks and TIPS, Swedroe notes. In 2000, 2001, and 2002, for example, S&P 500 returns were off 9.1 percent, 11.9 percent, and 22.1 percent, respectively. During those years, the Lehman Brothers Treasury TIPS Index returned 13.2 percent, 7.9 percent, and 16.6 percent.
Plus, as a TIPS investor, you can also get a little extra yield by buying longer-term maturities, and you'll still sleep easier than if you'd bought traditional treasuries, since you'll know that inflation won't eat up your returns. "Even in the Great Depression, we did not go 10 years with cumulative deflation," Swedroe says. "So buy a 20-year TIP. The real risk is inflation."
It may not be happening right now, but over time, commodities investments can offset swings in stocks and bonds. Commodities rise with inflation, which is negatively correlated with stocks and bonds. From 1973 through 2007, the Lehman Brothers Bond Index twice posted a negative return, once in 1994 and once in 1999, for an average 3 percent loss. In both years, the Goldman Sachs Commodity Index rose, for an average gain of 23.1 percent. During that same period, the S&P 500 had eight years of negative returns, and during six of those the commodity index was positive.
Plus, commodities tend to perform best when your portfolio needs them most. During times of strife or unexpected market shocks, commodity prices rise as supplies are threatened. Again, 2008 has been an exception, as commodities have fallen along with everything else because of slowing global demand.
Still, Swedroe says commodities can help you build a diverse portfolio. A dollop of commodities offsets the risk of inflation, allowing you to buy longer-dated bonds with higher yields. "If you're going to add commodities, then you can own a long-term bond fund. If you don't, you're better off with short or intermediate [bonds] to cut your risk of inflation," Swedroe says.
Annuities aren't for everyone, but for retirees considering how to make shrinking portfolios last, they're worth keeping in mind. Fixed annuities are contracts issued by insurance companies that provide regular payments until the end of the holder's life. They offer some of the best security against ups and downs in investment returns at a time when you'll be spending your hard-won gains in retirement.
A bonus: The payments you receive from putting a lump sum in an annuity can actually be higher than investing the same amount in a 30-year bond. Swedroe says a 60-year-old male taking out an immediate annuity will see a payout 20 percent higher than a 30-year treasury bond would produce, and if he lives past 90, the payments continue.
The obvious drawback to annuities is that if you die early, you generally lose the asset. But the peace of mind that comes with guaranteed income may make it worth taking that risk. "We insure so many things in our lives, but few people think about hedging longevity risk because they don't think of it as a risk," Swedroe says. "But you have the risk of outliving your money. It's the only way to hedge that."
Offered through retirement accounts, including IRAs, stable-value funds are a conservative answer for investors looking for just a bit more return than the usual money market fund provides. Stable-value funds are essentially agreements between an issuer and an insurer who agree to keep the fund's value stable. (Here is a more detailed explanation). Volatility and risk are generally low for stable value.
Stable-value funds invest in longer-dated bonds (typically one to three years) with higher yields than those of traditional money market funds, which hold short-dated treasuries. A 20-year study by the Stable Value Investment Association showed that such funds outperformed 30-day treasury bills by 3.2 percentage points a year, with only slightly higher risk.
However, stable-value funds aren't as transparent as money market funds (for instance, they can take credit risk or make other bets on riskier bonds), so investing in a highly rated fund is a must. "They're a nice enhancement for people who need a little more yield," Swedroe says.
One caution: Stable-value funds tend to do well when interest rates are dropping. That's great when short-term rates are falling, as they have been during this recession, but the funds could be less attractive when interest rates edge up from their currently low levels.
Corrected on 12/12/08: An earlier version of this article implied an inverse correlation between commodity prices and returns on equities and bonds. The correlation is negative.