Rick Welch: Dollars and $ense

Alternative Investments

Alternative investments include many different types of investments or assets which fall outside of the three primary or traditional asset classes known to most investors: cash, bonds and stocks.  An investment can be considered alternative if it includes or holds real assets, like real estate or natural resources.  Another alternative category is commodities, which are materials consumed or used to make other products. Examples of commodities include oil and natural gas; agricultural products such as corn, wheat and soybeans; livestock such as cattle and hogs; and metals like copper, nickel and zinc.  Lastly, an investment could be classified as alternative based on the investment strategy (examples include managed futures, hedge funds and private equity), which strategy may not be suitable for investment by the general public.

One method of distinguishing between traditional and alternative investments is by their return characteristics. As a group, alternative investments have expected returns that are uncorrelated or only slightly correlated with the expected returns of the three traditional asset classes.  An attractive dimension of this low correlation is that it indicates the potential to increase diversification within a portfolio of traditional assets.  When two assets have low correlation we expect that when the price of one asset goes up, the price of the other will go down. Remember that diversification which reduces risk, without effecting expected return, is a sound method of producing superior risk-adjusted returns in a portfolio.   

Real estate investment trusts (REITs) and master limited partnerships (MLPs) are two types of publicly traded alternative investments found in many portfolios. REITs are diversified portfolios of income producing properties, which portfolios cover many real estate categories including industrial, office, apartment buildings, shopping centers and malls, hotels, self-storage facilities and health-care.  With the lesser known MLP, investors buy units of a publicly traded partnership. MLPs typically own “midstream” energy assets which can include mining, process, transporation (marine, pipeline and road) and distribution activities.  REITs and MLPs are both “pass-through” entities which allow their investors to receive a rich yield, higher than the dividend yield of the S&P 500 Index and most fixed income asset classes.

Commodities are typically traded through futures contracts. A managed futures investment involves trading in commodities, global currencies and interest rates (and other financial instruments) through the use of derivatives (futures, forwards and options) on the basis of technical and fundamental analysis.  Managed futures investments employ investment strategies that are difficult to both explain and understand.   Hedge funds are privately managed investment funds that utilize sophisticated strategies, employ excess leverage, use derivatives and benefit from their less regulated nature to generate investment opportunities that are substantially different from opportunities offered by traditional asset classes.  Managed futures and hedge funds, both previously the domain of the high net worth investor, are now available to most investors.  With this availability, investors must take due caution.  These investment vehicles are quite complex, subject to wide swings and offer the potential for both deep losses and large gains.  If you see this type of investment in your account, ask your advisor to explain its strategy and the risks associated therein.  Please follow my rule of thumb, which is “If I cannot explain a particular investment or investment strategy in two sentences, then it probably is not appropriate for the average investor.”  

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