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Avoiding Mea Culpas With Alternative Assets

Roger Nusbaum

The Wall Street Journal recently published an article exploring the merits of alternative assets. It included mea culpas from investment managers who had invested too much in alternative assets and a look at several segments within that category.

There are ways the managers could have avoided those regrets. Let me explain.

I've been writing about investing in alternative-asset investing for several years, with the belief that a moderate -- let me stress the word "moderate" -- allocation can reduce volatility. I have found long-short mutual funds, exchange-traded products that track carbon credits, Norwegian fishery stocks, Malaysian plantation stocks and more. Learn about as many of them as you can, but invest selectively and in small increments.

When you start to conduct your own research, you will find various white papers telling you to put 20% in commodities or 20% in real estate investment trusts (REITs). Soon you end up with a portfolio of alternative assets hedged with just a little bit of equity exposure. In the WSJ article, there were quotes from asset managers with 15% to 20% in investments such as commodities, and there was regret. Commodities have had their own bear market, starting about eight months after the bear market in equities.

The first asset class profiled in the article is real estate, via REITs. I have given up on REITs as a diversifier, having sold the one REIT I owned for clients in December 2007. The correlation to financial stocks was very high and, while all correlations generally increased among many asset classes in this bear market, the link between REITs and financial stocks rose very early in the bear market. The Journal article theorizes that REITs have lost their appeal for diversification for being over-owned. Maybe that is correct but, either way, I'm inclined to think of REITs as a subsector of financials and not a portfolio diversifier.

Commodities may have been a bigger disappointment than REITs. The article says there are 238 ETFs and ETNs, and a lot of them were down a lot in 2008. The decline could have been because they had too large of a run-up, or the pricing-in of a global slowdown, or both. For example, United States Oil ETF (USO Quote) and iPath AIG Nickel ETN (JJN Quote) were each down more than 50% in the past year, and the e-Tracs CMCI Long Platinum ETN (PTM Quote) fell a similar amount since May, when it was first listed.

I am a believer in having a moderate exposure to commodities for a couple of reasons. Gold has a track record of going up when there is an external shock to the market, such as on Sept. 11, 2001. In that light, it becomes more of an insurance policy. If inflation does get out of hand and gold benefits from that, fine, but my primary interest is protection against a shock.

There is also a supply-and-demand story with various segments of the soft and agricultural commodity space. This ties in with an ascendancy of a middle class in many emerging markets.

Part of that ascendancy is a healthier diet with more protein. This theme, which I would expect to be played out over many years, will have bumps along the way. But with prices being down, I recently added PowerShares Agricultural ETF (DBA Quote) for clients. Between DBA and SPDR Gold (GLD Quote), clients' total exposure to commodities is around 5%.

2008 Performance: DLSAX, RYMFX and DIAMX TradeStation

The final alternative segment the Journal looked at was what it referred to as "hedge strategies." I've written several times about a few mutual funds that operate in this space. Last year I added the Rydex Managed Futures Fund (RYMFX Quote) for clients, and recently I added the Dover Long Short Sector Fund (DLSAX Quote). Both are absolute return funds that weathered the 2008 bear market very well. Not all funds in this segment fared as well.

The Diamond Hill Long Short Fund (DIAMX Quote), for example, dropped about 25% in 2008. That makes an argument for modest exposure. There is nothing that says funds that did well in the last bear market will do well in the next one, which is why RYMFX and DLSAX combine to account for less than 5% of the portfolios I manage.

The idea in going so small is to avoid the regrets expressed in the WSJ article. These things should work, but, of course, should does not ensure they will work. I've been preaching moderation long before the bear market started and will continue to do so in the future.