Investors are facing a problem. Low interest rates and yields have them taking on more risk in order to find good income sources. Even then, bond funds that track less-than-stellar credits- like the SPDR Barclays High Yield Bond (NYSE:JNK)- are now yielding historically low amounts.
Equities haven’t been so hot lately either. Headline risk is back with a vengeance. As such, stocks have once again returned to their pattern of big up and down swings. Volatility can be a portfolio killer and leads to plenty of sleepless nights.
This could explain why investors are flocking to alternative investments in spades. Following the lead of pensions and hedge funds, individual portfolios are filling up with unique asset classes and allocations. With many analysts predicting rough waters ahead for the foreseeable future, these alternatives may just be what a portfolio needs in order to cross the finish line.
Not Just For Institutional Investors
Institutional investors and affluent individuals have always dabbled in alternative investments. However, retail investors -through the boom in alternative ETFs and mutual funds- have now begun adding the investments in spades. According to mutual fund powerhouse Fidelity, 22% of net mutual fund inflows were into alternative investment mutual funds. That echoes similar results for various new alternative ETFs as well. All in all, Chicago-based Morningstar (Nasdaq:MORN) pegs that investment in alts is growing at about a 20% annual clip.
There are plenty of reasons why investors may want to consider following their leads.
While the investments' strategies at first blush may seem complex, the basic principal is to find a way to generate consistent returns without the volatility associated with the stock market. At the same time, provide more “oomph” to a fixed income portfolio. By creating a portfolio that has many independent moving parts, investors are able to gain high returns while limiting overall risk.
Then there are correlations to consider. Overtime, correlations between asset classes are growing closer together. Between 1994 and the end of 2013, both developed and emerging international stocks had a correlation of 80% and 72% with the S&P 500. Even the benchmark bond index- the Barclays Capital U.S. Aggregate Index (NYSE:AGG) -has shown positive correlations with stocks during that time. Alternative asset classes like commodities, currencies and managed futures still offer low correlations to stocks and bonds. And in some cases, they offer negative correlations- a role that used to be more closely provided by bonds.
All in all, investors can think of alts as a way to regain the diversification benefits they have been losing.
Adding The Powerful Portfolio Tools
Historically, adding alternative assets has been very costly and almost impossible for the little guy to gain exposure to. Yet, the ETF boom has allowed individual retail investors the ability to access hedge funds, long-short strategies and other areas of the market previously off limits. Here are some of the best picks.
The $700 million IQ Hedge Multi-Strategy Tracker ETF (NYSE:QAI) could be an interesting starting point. As one of the oldest alts ETFs, the fund is basically a hedge fund in one ticker. QAI hopes to replicate risk-adjusted returns of hedge funds using various hedge fund investment styles. It does this by using other liquid ETFs. Current top holdings include the Vanguard Total Bond Market (NYSE:BND) and PowerShares Senior Loan (Nasdaq:BKLN). So far, QAI has managed to provide consistent returns since its inception. Another broad hedge fund style ETF choice could be the ProShares Hedge Replication ETF (NYSE:HDG).
The biggest category of alts fall under the managed futures banner. These strategies take advantage of price trends across different futures contracts including commodities, currencies and stock index derivatives. The WisdomTree Managed Futures Strategy (Nasdaq:WDTI) tracks the Diversified Trends Indicator- which is the benchmark managed futures index. So far, performance for WDTI has been pretty poor as commodities have fallen by the wayside and stocks have rallied. However, that highlights WDTI’s non-correlated status.
Finally, market neutral or absolute return strategies could be winners as volatility returns to the market. The new First Trust High Yield Long/Short ETF (Nasdaq:HYLS) goes long on junk bonds while shorting treasury bonds to profit from the spread and reduce interest rate risk, while the Credit Suisse Merger Arbitrage ETN (Nasdaq:CSMA) uses M&A to profit. CSMA seeks to gain from the spread between when an acquisition is announced and the final purchase price is made. Both funds won’t “hit it out of the park,” but will deliver consistent returns for portfolios.
The Bottom Line
Taking a cue from institutional managers, retail investors now have a sophisticated set of tools at their disposal for finding new and uncorrelated asset classes. These alternatives could do your portfolio wonders. The previous picks- along with the SPDR SSgA Multi-Asset Real Return ETF (NYSE:RLY) –make interesting alternative buys.