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Alternative investments provide diversification
Published on Monday, Nov 24, 2008
Sometimes the right thing comes along at the right time. That was my first thought when I read the uncorrected proof copy of The Only Guide to Alternative Investments You'll Ever Need (Bloomberg Press, $26). Written by Larry Swedroe and Jared Kizer, the book takes us on a guided tour of ''alternative'' investments — everything beyond day-to-day domestic stocks and bonds.
Read it and you might avoid jumping from the frying pan of the current stock market into the proverbial fire — to an investment that might involve still more risk and still less return than you've experienced in the last year. Swedroe is head of research at Buckingham Asset Management LLC, an advisory firm that also manages money for other firms.
They don't, however, pick individual stocks or bonds. Instead, they build portfolios from indexes that represent asset classes such as large-capitalization domestic stocks, small-cap international value stocks and short-term government bonds. Their goal: capture the return of an asset class as efficiently as possible. They don't try to ''beat the market.''
This is important because it defines their framework for evaluating alternative investments. It also helps them make clean, un-hedged calls. They divide the universe of alternative investments into four easily understood categories — the good, the flawed, the bad and the ugly.
So what's good? And what's ugly?
I can't go through every alternative investment, but here are a few.
Real estate (generally in the form of REITs) is good. So are inflation-protected securities such as TIPS. And so are international equities, life annuities and stable value funds.
Virtually all the other investments that we hear so much about (and that attract hundreds of billions of dollars every year) are either flawed, bad or downright ugly.
Real estate, generally in the form of real estate investment trusts, is on the ''good'' list, because adding it to a portfolio can increase portfolio return without increasing risk. Swedroe and Kizer point out that a portfolio of U.S. stocks provided an annualized return of 12.9 percent from 1978 through 2007, with a standard deviation (a measure of risk) of 15.3 percent. Making that portfolio just 10 percent REITs, however, increased the return to 13.2 percent, while decreasing the risk to 14.4
percent. This is the benefit of broad diversification.
Investing in commodities via the new exchange-traded funds is applauded for the same reason. While the S&P 500 returned 11.41 percent annually from 1991 through 2007, with a standard deviation of 17 percent, adding just 5 percent of a commodity index kept the return about the same, 11.42 percent — but reduced risk to 15.94 percent.
For Swedroe and Kizer, the test of any investment is whether it will make a portfolio more efficient — to produce a higher return at lower risk. They search for this because it has a very unstatistical result.
The more efficient your portfolio, (1) the better your chance of having more money to spend in retirement and (2) the greater the odds you won't outlive your money.
Feeling sad that you don't have enough money to participate in the fancy world of private equity investments? Don't. Swedroe and Kizer see such investments as flawed. They dramatically increase risk and expenses without providing proportionately increased returns.
One study they cite found that before accounting for fees and profit-sharing, the average private equity fund beat the S&P 500 by 3 percent a year. But after those expenses, the average private equity fund trailed the S&P 500 by 3 percent a year. Adjust for lack of liquidity (you can't just sell your private equity investment when you want; you have to hold it for a long time), and private equity deals are far better for the managers than for the investors.
And don't shed any tears about not being a ''qualified investor'' and, therefore, not being allowed to invest in hedge funds. The authors' well-documented research shows that a typical hedge fund has to beat the market by about 6 percentage points a year, before fees and expenses, just to provide the return of a passive investment in a stock index.
Surprised to see variable annuities are on their ''bad'' list? Not if you're a regular reader of this column. They find, as I have, that the expenses of variable annuities exceed the benefits.
Compare the good, flawed, bad and ugly investments, and you'll find a trend. Good investments are direct, relatively unpackaged and relatively low in expenses. The worse an investment is, the greater the odds that it is heavily packaged and complex.
Their advice: ''Avoid complexity because the complexity is almost certainly designed in favor of the seller.''
Questions about personal finance and investments may be sent by e-mail to scott@scottburns.com or by fax to 505-424-0938. Please visit my Web site at www.scottburns.com to comment on any of my articles, find referenced Web links or to discuss personal finance topics on my forums. Questions of general interest will be answered in future columns and on my Web site.
Sometimes the right thing comes along at the right time. That was my first thought when I read the uncorrected proof copy of The Only Guide to Alternative Investments You'll Ever Need (Bloomberg Press, $26). Written by Larry Swedroe and Jared Kizer, the book takes us on a guided tour of ''alternative'' investments — everything beyond day-to-day domestic stocks and bonds.
Get the full article here.
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