The age-old diversification strategy of reducing risk by moving more into bonds won’t work so well in a rising interest rate environment, as this may increase risk rather than decrease it. So, many are looking for other means of diversification. Increasingly, they’re considering alternative investments — broadly defined, anything other than stocks or bonds. The goal of owning “alts” is to add to portfolios risk/reward potential that’s not correlated with the movements of stocks or bonds, aka traditional investments.
Access to many alternative investing options is readily available through various exchange-traded funds, including those owning commodities, currencies, managed futures and real estate investment trusts. But this easy access can get you into trouble if you don’t take the time to learn about the unique risks an alt may carry. Understanding some alts and their risks may require more homework than most individual investors are willing to take on.
This might apply to commodities, which can be downright esoteric. For example, agricultural commodity investing involves understanding how yields of particular crops may be affected by changes in seasonal weather patterns. And how much time are you willing to invest in studying supply/demand for rail cars?
In the run-up to the financial crisis of 2008, complexity didn’t seem to bother a lot of (or enough) investors who bought the granddaddy of indecipherable alts — derivatives. Yet there’s as much complexity in many alts that are far less abstract than derivatives. Just because a commodity is concrete doesn’t mean it’s not complicated.
REITs can be counted among the more accessible alts, and they can deliver good returns while diversifying risk. Yet investors must be mindful of the differences between various real estate markets. For example, residential REITs recently have been doing quite well, driven by demand that’s still somewhat pent up from the market doldrums of the financial crisis of 2008.
But some commercial REITs, such as those that depend on mall rents, are another story now that online retailing is bruising many bricks-and-mortar chains. Instead of places where people walk around to shop, think warehouse space/fulfillment centers for online retailers and server space for the rapidly growing cloud storage industry.
Regardless of the category, alt investing can be costly, and the high fees sometimes involved can significantly reduce your net returns. A recent study by the Boston Consulting Group found that, at the end of 2016, alts made up about 15 percent of global assets under management but accounted for 42 percent of the fee revenue generated by asset management firms offering alts.