The financial crisis changed the way many individuals and money managers think about portfolio construction. Many are now questioning whether holding basic stock funds like the Vanguard Total Stock Market ETF (NYSE:VTI) is enough to see themselves through into retirement. Burned by losses during the financial crisis, many investors are now turning towards alternative strategies to generate returns. Following the lead of endowments and hedge funds, individual's portfolios are filling up with unique asset classes and allocations, such as commodities and 130/30 tactics. 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.
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Moving Beyond Just Stocks
Institutional investors such as hedge funds, endowments and pension funds have always dabbled in alternative investments. Now, retail investors have the ability to participate in such asset classes. The number of alternative mutual funds and ETFs has doubled since 2007 and the assets under management have tripled to nearly $138 billion. While most of those funds are tilted towards the commodity and real estate sectors, over the past year many new funds have launched that emulate strategies typically found in expensive hedge funds for high-net-worth investors. Regular retail individuals tilting a portion of their portfolios towards these hedge-fund-like investments can provide many of the same benefits. By creating a portfolio that has many independent moving parts, investors are able to gain high returns while limiting overall risk. Financial advisors are certainly in agreement. Nearly 36% of advisors surveyed by Morningstar say that these alternatives will become important for portfolios than traditional investments like stocks, over the next few years. This is up from 13% pre-crash.
Adding Those Portfolio Diversifiers
Historically, these alternative assets have been very costly and almost impossible for the little guy to gain exposure too. One of the big benefits of the ETF boom is that individual retail investors now have the ability to access hedge funds, long-short strategies and other areas of the market previously off limits. Anyone with a brokerage account can now tap a hedge fund manager.
One strategy that is gaining immense popularity is managed futures. At its core, managed futures strategies take advantage of price trends across different futures contracts including commodities, currencies and stock index derivatives. Both the WisdomTree Managed Futures (Nasdaq:WDTI) and iShares Diversified Alternatives Trust (NYSE:ALT) allow investors to tap into the strategy. Both charge just 0.95%, which is quite cheap considering that the average manage futures fund charges 2% plus a piece of the profits. For investors looking to focus strictly on the commodities side of managed futures, the ELEMENTS S&P CTI ETN (NYSE:LSC) allows portfolios to take that bet.
Absolute return funds seek to make positive gains by employing investment management techniques that differ from traditional mutual funds. Generally, these funds are uncorrelated to stock market returns. Playing volatility has become popular with traders as a way to capitalize on the markets short term movements. The UBS E-TRACS Daily Long-Short VIX ETN (NYSE:XVIX) allows investors to tap into the inefficiencies in the VIX futures curve. The fund provides 100% long exposure to midterm VIX futures and 50% short exposure to short-term VIX futures. Over the last six months, the fund has returned about 1%. However, the goal of absolute funds is to provide continued gains in any market, not necessarily knock the ball out of the park. (For more on the VIX, see 4 Ways To Trade The VIX.)
Merger arbitrage is another example of an absolute strategy. The strategy seeks to profit from the spread from when an acquisition is announced and the final purchase price. Investors can exploit this trend in M&A through the IQ ARB Merger Arbitrage ETF (NYSE:MNA). Current holdings include Family Dollar Stores (NYSE:FDO) and Bucyrus (Nasdaq:BUCY).
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. The preceding ETFs, along with funds like the ProShares RAFI Long/Short (Nasdaq:RALS) could be just what a portfolio needs to cross the finish line.
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