When financial advisers tell you to diversify, diversify, diversify, they're also saying beware of "correlation"—the tendency of certain asset types to move in tandem. Interest rates, for example, move more or less together, as do the stocks of certain companies and industries.
Analysts measure correlation using coefficients, where 1 represents perfect correlation and zero none at all. Some asset classes actually have negative correlation, meaning that when A rises, B falls. You might do well with a highly correlated portfolio when markets are generally rising, but high correlations can be disastrous when markets fall. In a panic, as they say, all correlations go to 1.
Lots of folks think of diversification as a binary trade-off between stocks and bonds. But there are alternatives to those traditional assets—and that's exactly what they're called. "Alternative" investments are usually defined as things like real estate and commodities, but they can include just about anything, from collectibles to obscure derivatives, even timber. There is no universally accepted definition of "alternative," a word that can describe strategies as well as holdings.
However defined, alternative assets are not easy for most investors to buy on their own. They're usually the province of private-equity and hedge funds, which are typically for wealthy investors. Just try to buy your own emerging-market corporate bonds, preferred shares, or put option on some commodity-futures contract.
There is, however, a relatively new and growing universe of funds that allow retail investors to get in on the alternatives action. Investment-research firm Morningstar is expanding its coverage of alternative mutual funds, a category it says drew net inflows of $23 billion last year, compared with net outflows of $85 billion for conventional mutual funds. Alternative ETFs attracted net inflows of $10.8 billion, compared with $109 billion for traditional ETFs. Both flow totals shrank a bit last year, which ended with alternative-ETF assets at about $145 billion and alternative mutual-fund assets at about $122 billion.
What's driving interest is the search for diversification in a world of low yields and high volatility. But are alternatives a good fit for the typical investor? After all, they employ strategies that most investors find obscure and confusing. Some examples: the Quaker Event Arbitrage fund (symbol QEAAX), which tries to anticipate corporate mergers, and the Merk Hard Currency fund (MERKX), which bets on a weakening dollar. Among the older alternative strategies are so-called long/short funds, which invest part of their holdings in "short" positions—essentially bets that prices will fall.
Then there is the fast-growing alternatives category known as managed futures, which uses quantitative models and derivatives to exploit short-term trends in currency, equity, commodity, and interest-rate markets. For now, the only managed-futures mutual fund to which Morningstar assigns a positive rating is AQR Managed Futures Strategy I (AQMIX).
AQR stands for Applied Quantitative Research. Using an automated program, the fund tries to identify market trends on two time horizons—three months and one year—and looks for signs that a trend is about to reverse itself. Launched in early 2010, the fund fell 6.4 percent last year, about in line with its peers. Nonetheless, Morningstar's Terry Tian writes, that the fund's "investment process is sound."
If such strategies are hard for many investors to grasp, it's probably just as well—most probably don't want to bother. Broadly, alternatives funds are sold as tools to enhance a portfolio's diversification and provide consistent returns—or at least that's part of the argument for them. They do that by reducing downside risk, but also by reducing upside potential.
In 2008, when the S&P 500 fell 37 percent, the funds in Morningstar's open-ended long-short category fell 15.4 percent. When the S&P surged 26 percent the following year, the long-short category gained only 10.4 percent. It's up an annualized 5.6 percent for the past three years, compared with 15.6 percent for the S&P.
Many alternative funds offer "bond-like returns with correlations that are very different from equities as well as bonds," says Morningstar alternatives analyst Josh Charney. "Most have a volatility range that's somewhere between equities and bonds."
When sizing up alternative strategies, Charney says, investors should be looking not at absolute return—the number that shows up on your quarterly statement—but returns that are adjusted for risk. Professionals do that using Sharpe ratios and other arcane metrics, but there's a simpler way, says Alan Reid, CEO and co-founder of Forward Management, investment adviser to Forward Funds.
"The easiest way for [investors] to think of it is to count the number of bad periods," says Reid. "If the alternatives manager is adding value, you should see considerably fewer negative periods than positive periods."
To be sure, there are things you should know about alternative funds before you leap into them. For one, their fees are much higher than the 75 basis points (bps) that the average mutual fund charged last year. Excluding nontraditional bonds, they ranged from 142 bps for currency strategies to 287 bps for managed futures.
"The fees don't seem to be commensurate with the return goals," says Morningstar's Charney. "Investors need to understand that. We've started to harp on that point, and we probably should a little bit more."
Investor psychology can pose problems, too. Morningstar research has shown that the average investor does worse in alternative funds than in traditional funds, because of poor market timing, one the biggest faults of retail investors. There is often a significant gap between total returns and what Morningstar calls "investor returns"—what an investor actually experiences depending on when she enters or exits a fund. But the gap is considerably wider for alternative funds than for traditional funds, Morningstar says, partly because people tend to view them as short-term, non-core holdings that suddenly feel dispensable when markets start slipping.
How much should investors allocate to alternative strategies? Morningstar's Charney says it depends on your appetite for risk, and recommends gradually allocating to the category. One thing to keep in mind is that today's alternative assets are tomorrow's core holding. A decade ago, real estate and commodities were considered alternative assets. Now, not so much. In fact, says Reid, whose firm offers several alternative funds, the riskiest portfolio is not one with alternatives but one with no alternatives.
"I would be more comfortable in a group of alternative funds than being 100 percent in the S&P index," says Reid. "Someone looking for highest return—in emerging markets, small caps, high-yield—typically wouldn't have alternatives. Alternatives are for the middle market, if you will—not those investors looking to hit the sky, but those seeking consistent rates of return."