Should You Have Alternative Investments In Your Portfolio?

So you have discovered the merits of dumping your high-priced money manger and his ineffective mutual funds in favor of low-cost index funds allocated across stocks, bonds, and cash.

You have diversified your portfolio to reduce risk and increase your likelihood of a good retirement. Congratulations! By focusing your attention on what matters most—finding the right mix of stocks, bonds, and cash—and keeping your allocation on target through steel-veined rebalancing, you have elevated your portfolio into the top 10 percent and are enjoying the company of the top endowments and of wealthy families. You are no longer the stock market’s dog taking its daily beating.

As you have grown in sophistication, you have also become aware that the big players use alternative investment vehicles—hedge funds, private equity deals, absolute return strategies, and venture capital—to further increase diversification and elevate returns.

Take a look at Yale’s endowment manager David Swensen. One of the leading evangelists for low-cost index investing across stocks, bonds, and cash, Swensen follows a different path for the endowment he manages. In his portfolio you will find a hefty allocation to alternatives, namely 50.6 percent across absolute return strategies and private equity as of 2010.

Why does Swensen make so much room for alternative investments? There are several reasons. One such rationale is that alternatives provide real diversification within the university’s portfolio. While equities from the United States, foreign developed countries, and emerging markets sometimes seem to move in lockstep, alternative investments are more likely to zig when corporate stocks zag. That accomplishes a big goal of diversification. Another reason is something called risk-adjusted returns. For just a little more risk, Yale is able to increase its returns over a ten-year period by approximately 4 percent annually. That’s a bet they want to take.

So to truly follow the endowment model, you would think that alternatives should be represented in your portfolio as well. Additionally, in recent years, a new class of mutual funds has emerged, giving regular investors access to alternative deals that they were once locked out of. Is it time for you to board the alternative investment train?

Probably not. Here are four reasons the average guy should be cautious:

Qualification. The SEC has set rules about who can participate in alternative investments. Because alternative vehicles do not fall under the same SEC regulations and oversight as public stocks, and because there is a history of volatility and increased risk, the rules now state that to participate, you must be an accredited investor who has earned $200,000 annually for the past three years or who has a net worth, excluding home equity, of $1 million or more. The assumption is that a person with those assets is more sophisticated and more able to assess and survive the risks involved. And if you are not bringing a minimum of $500,000 to the game, there is no need to apply. Most funds set that amount as the minim hurdle for participation. Alternative investment mutual funds, however, have removed qualification barriers by allowing average investors the opportunity to pool their funds and participate.

Quality. Access is one thing, but quality is the bigger issue when it comes to alternatives. It doesn’t help to gain access to alternatives if you’re buying into the leftovers and walking dead, as the VC world calls them. Access to the best managers and funds is highly sought after, and a serious competition rages between endowments and wealth managers commanding billions of dollars of assets. Your little alternative mutual fund is the yapping Chihuahua that is fighting for his chance at the dog bowl while the pit bulls ravish the meal.

Fees. Even if you do luck out and find your way into a quality alternative fund, beware of the fee structure. While the institutional investors are able to knock down fees, the average Joe can expect to pay a 2 percent annual management fee and another 20 percent on all profits before he gets money out. Under the mutual fund model, add another onerous layer of management fees, usually around 2 percent annually, plus marketing fees and sometimes additional loads. Your underlying investments better include the next Facebook if you expect to see stellar returns.

Visibility and transparency. Finally, there is the issue of the visibility of your investments and the transparency of management. If David Swensen calls up ACME Enterprises to get an update on his European private equity holdings, his call will be taken and the discussion will be deep and wide. If you call your mutual fund provider to find out about how your investment in XZY Ventures is going, you will be put on hold until you go away. You have no shot of really understanding anything that is happening with your investment dollars short of what the mutual fund managers provide in their polished quarterly reports. And if the house starts to burn, count on being the last dog out the doggie door.

Big, smart money has ways of accessing alternative deals the average guy has a hard time understanding, let alone selecting. Alternative investment mutual funds can provide access to some high-priced leftovers. Smart access to alternatives comes in the form of index funds pointed at real estate through U.S. and international REITs and commodities in the form of U.S. and global energy and precious metals investments. These alternatives technically fall outside the typical stock/bond mix and provide real diversification via low-cost and reasonably transparent investments. Include these alternatives in your portfolio mix. If you try to play in the alternative world with the big dogs, you’re likely to end up with leftover dog meat that will leave you growling.