Should You Buy "Alternative" Asset Classes?

I've been meaning to pick on the darling of the alternative asset classes: gold. According the Macrotrends, gold has returned an annualized return of 1.90% over the last 40 years*. While there is some evidence this asset class has provided a diversification benefit during market declines, the reality is gold has experienced massively long periods of decline and stagnation. Investors trying to reduce risk have historically been better off using my Recommended Bond Approach (#4). Historically, bonds have returned 7.70%** with less risk than gold.

If you're still not convinced, consider investors who bought into alternatives in 2009 and 2010 after a scary Great Recession experience. The pitch sounds great, and even I got caught up in it back in the day: Investments need downside protection, and long/short equity, commodities, managed futures, non traded real estate, master limited partnerships, and hedge funds will protect you. To buy into these magical sounding alternatives, investors sold their stocks at a relative low point, locked in their losses, and invested in alternatives which had lower expected returns. They got left way behind as the stock market delivered fantastic gains from March, '09 and on. Had investors simply stuck with stocks and bonds, they would've been better off.

In the September, 2015 article Doing the Math on Liquid Alts' Five Year Track Record, author Brad Zigler charts how much bang for their buck investors received (financial nerds call this a Sharpe Ratio) using data from actual mutual funds. The only funds that beat a basic stock/bond allocation were two income based strategies; not exactly what the majority of investors are looking for.

His analysis doesn't mean the income based funds saw a higher return than the basic stock/bond allocation. It merely demonstrates that for every unit of risk the bond funds took, they delivered a higher return than that same unit of risk applied to the stock/bond allocation.

Commerical real estate (dark blue) as an alternative asset class is one I'm torn on. Historically, it has experienced growth above that of both stocks (green) and bonds (light blue), which is enticing. But, I'm not convinced real estate exhibits enough of the necessary criteria for portfolio integration. For example, real estate has mostly followed the same ups and downs at the same time stocks have. The whole point of diversifying is to hold some investments that zig while your others zag. The net effect being a smoothing out of returns, decreased expected loss, and help staying invested when our brains are pushing the panic button.

Real estate is especially interesting beacuse it was a beautiful diversifier as the tech bubble burst in 2000. But, it became highly correlated with stocks during the financial crisis spanning '07-'09, rendering it a useless diversifier during that decline.

It's been 13 years since we've seen real estate act like as a true diversifier. Academic study tells us we should be prepared to wait these lengths of time in order to realize investment strategies. But that's a tough pill to swallow.

I suppose the most compelling argument against real is that it's taken almost 20% more risk per unit of return compared to stocks***. When analyzing investments, we should seek those that deliver a lower risk per unit of return compared with other options. Perhaps in very growth oriented portfolios where we care less about risk and more about return, one could make an argument holding real estate would've enhanced the total return of the portfolio. So there's that...

Investors benefit when they diversify broadly, but that doesn't mean they should own every type of asset class. It's beneficial to know what you own in your investment accounts, and always remember that investments pitched as low/no risk for substantial return are too good to be true.

If you recognize any of the alternatives mentioned in this post in your portfolio, it might be worth a look to see if they're really making a valid contribution given your risk tolerance and time horizon. If not, it's probably ok to Simply Things with some portfolio restructuring.

* Gold Price: PM London Fix, January 1976 - January 2016.

** Source: Returnsweb, courtesy of Dimensional Fund Advisors, January 1976 - January 2016.

*** Source, Returnsweb, courtesy of Dimensional Fund Advisors, data time period January 1978 - January 2016.

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