Beyond Traditional Asset Classes: Exploring Alternatives

Stocks, bonds, and cash are fundamental components of an investment portfolio. However, many other investments can be used to try to spice up returns or reduce overall portfolio risk. So-called alternative assets have become popular in recent years as a way to provide greater diversification.

The term "alternative asset" is highly flexible; it can mean almost anything whose investment performance is not correlated with that of stocks and bonds. It may include physical assets, such as precious metals, real estate, or commodities. In some cases, geographic regions, such as emerging global markets, are considered alternative assets. Complex or novel investing methods also qualify. For example, hedge funds use techniques that are off-limits for most mutual funds, while private equity investments rely on skill in selecting and managing specific businesses. Finally, collectibles are included because the value of your investment depends on the unique properties of a specific item as well as general interest in that type of collectible.

Each alternative asset type involves its own unique risks and may not be suitable for all investors. Because of the complexities of these various markets, you would do well to seek expert guidance if you want to include alternative assets in a portfolio.

Hedge funds are private investment vehicles that manage money for institutions and wealthy individuals. They generally are organized as limited partnerships, with the fund managers as general partners and the investors as limited partners. The general partner may receive a percentage of the assets, fees based on performance, or both.

Hedge funds originally derived their name from their ability to hedge against a market downturn by selling short. Though they may invest in stocks and bonds, hedge funds are considered an alternative asset class because of their unique, proprietary investing strategies, which may include pairs trading, long-short strategies, and use of leverage and derivatives. Participation in hedge funds is typically limited to "accredited investors," who must meet SEC-mandated high levels of net worth and ongoing income (individual funds also usually require very high minimum investments).

Like stock shares, private equity and venture capital represent an ownership interest in one or more companies. However, unlike stocks, private equity investments are not listed or traded on a public market or exchange, and private equity firms often are involved directly with management of the businesses in which they invest.

Private equity often requires a long-term focus. Investments may take years to produce any meaningful cash flow (if indeed they ever do); many funds have 10-year time horizons. Like hedge funds, private equity also typically requires a large investment and is available only to investors who meet high SEC net worth and income requirements.

You may make either direct or indirect investments in buildings--either commercial or residential--and/or land. Direct investment involves the purchase, improvement, and/or rental of property; indirect investments are made through an entity that invests in property, such as a real estate investment trust (REIT). Real estate not only has a relatively low correlation with the behavior of the stock market, but also is often viewed as a hedge against inflation.

Investors have traditionally purchased precious metals because they believe that gold, silver, and platinum provide security in times of economic and social upheaval. Gold, for instance, has historically been seen as an alternative to paper currency and therefore may help hedge against inflation and currency fluctuations. As a result, gold prices often rise when investors are worried that the dollar is losing value, though prices can fall just as quickly.

There are many ways to invest in precious metals. In addition to buying bullion or coins, you can invest in futures, shares of mining companies, sector funds, and exchange-traded funds (ETFs).

Direct investments in natural resources, such as timber, oil, or natural gas, can be done through limited partnerships that provide income from the resources produced. In some cases, such as timber, the resource replenishes itself; in other cases, such as oil or natural gas, it may be depleted over time. Timberland also may be converted for use as a real estate development.

Commodities are physical substances that are fundamental to creating other products or to commerce generally. Commodities are basically indistinguishable from one another. Examples include oil and natural gas; agricultural products such as corn, wheat, and soybeans; livestock such as cattle and hogs; and metals such as copper and zinc.

Commodities are typically traded through futures contracts, which promise delivery on a certain date at a specified price. Futures contracts also are available for financial instruments, such as a security, a stock index, or a currency. Though the futures market was created to facilitate trading among companies that produce, own, or use commodities in their businesses, futures contracts also are bought and sold as investments in themselves, and some mutual funds and ETFs are based on futures indexes.

Futures allow an investor to leverage a relatively small amount of capital. However, they are highly speculative, and that leverage also magnifies the potential loss if the market does not behave as expected.

Some investors are drawn to these because art, antiques, gems, and other collectibles may retain their value or even appreciate as inflation rises. However, those values can be unpredictable because they are affected by supply and demand, economic conditions, and the quality of an individual piece or collection.