Do Alternative Investment Funds Actually Work?

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The traditional portfolio consists of stocks and bonds and little to nothing of other asset classes. Adding more than that to the mix has generally been left up to professionals to handle. But with the advent of ETFs and other asset creations, everyday investors now have relatively easy access to all sorts of alternative investments from futures to long/short equity funds to derivative investments.

Investors can use alternative investments to boost returns or mitigate risk and with a plethora of options to choose from, there’s virtually no strategy off-limits. The market for alternatives is growing fast with more than $300 billion invested in alternative mutual funds and ETFs as of 2012. Giving investors the ability to profit in any type of market seems like a powerful tool, but with limited data, their actual effectiveness varies.

The role of alternatives in a portfolio

The alternative investment space can be broken up into five main categories: equity-based funds, nontraditional bond funds, commodities, multi-currency funds, and derivatives. Let’s take a look at how each one applies to a portfolio.

The equity-based category can be broken up further into three subsets: bear market funds, long/short funds, and market neutral funds. Bear funds specialize in short selling and other strategies aimed at profiting from down markets. Long/short funds hold net long positions but hedge against downside risk with some short calls. Market neutral funds are designed to profit from markets that trade sideways and don’t have a lot of volatility. Bear and market neutral funds are designed for short-term use only though and shouldn’t be held in a long-term portfolio.

Nontraditional bond funds invest in bonds but may use a variety of strategies to reduce interest rate risk or take advantage of high-yield debt holdings. This aggressive bond strategy shouldn’t be confused with other types of bond holdings which are generally classified as conservative.

Commodities can be invested in a number of ways. Investors can directly invest through futures, or choose ETFs to take advantage of individual commodities or groups of commodities like agriculture. Investors can even choose to stick with stocks that are heavily tied to a commodity like mining companies.

The multi-currency category involves investing the relative differences between two or more currencies. Usually, these funds short the US dollar and take a long position in a different foreign currency. The higher-yielding currency is usually the long position while the lower yielding one is shorted.

Finally, the derivatives category rounds out our list. It comes in several different forms like equity funds did: managed futures, volatility funds, and inverse/leveraged funds. Managed futures invest directly in futures but come in a more compatible asset class like ETFs allowing them to be traded as easily as stocks. Volatility funds take long or short positions on the VIX, the popular Wall Street “fear gauge.” And lastly, inverse/leveraged funds make up the largest category of alternative funds and allows investors to take inverse or leveraged positions in a variety of assets.

Final considerations

Investors interested in alternative funds should carefully consider the risks. Many of these types of asset classes are designed for temporary use and come with higher-than-usual risk. Limiting alternative funds to 20% or less of your portfolios total holdings will help reduce the risks involved and take it to the next level.