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Why Alternative Investments Should Still Play a Role in Your Portfolio By Cindy Rapponotti, CFA®, CAIA®
August 3, 2017

What is an “alternative investment?” Some investors may hear the term from time to time and simply think of it as an exotic type of security available only to the very wealthy.

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However, you may be more familiar with alternative investments than you realize. Real Estate Investment Trusts or REITs, Hedge Funds, Infrastructure/Energy Master Limited Partnerships or MLPs, and Commodities are all considered “alternative” investments when compared to traditional investments such as stocks, bonds and money market funds.

Since the economic and market recovery that began in 2009, Hedge Funds and other alternative investments in general have not kept up with equity and fixed income returns. Even the last five years have been disappointing as a 60% S&P 500/40% Bloomberg Barclays Aggregate Bond portfolio returned 9.64% versus the Hedge Fund HFRI Fund of Funds Conservative Index return of 3.68% (returns are annualized). Despite the recent challenges, we still believe that Hedge Funds and other alternative funds have a place in portfolios as market conditions change and the appetite for risk declines.

Alternative investments remain attractive as they can help you reduce risk by diversifying your portfolio. In fact, many consider them an insurance policy in their portfolios as alternative investments often zig when the market zags due to lower correlations, by design, to the traditional asset classes of stocks and bonds.

While sophisticated investors may make more use of alternative strategies, the fact is that alternative investments of varying kinds are readily available to investors through mutual funds and/or exchange traded funds. It’s not unusual, for instance, to have a REIT mutual fund option in an employer’s 401(K) plan menu. Many REITs trade on the major stock exchanges and can be purchased or sold through brokers.

The range of choices in the alternative investments asset class have return and risk profiles that vary from high return/high risk to low return/low risk. For example, REITs and MLPs have high return/high risk profiles as they are a subset of the U.S. Equity market. They have features that may be attractive during different economic cycles or inflationary periods, or may offer higher income or dividend distributions than traditional stocks or bonds.

We have a positive outlook on the energy MLP sector despite its lagging performance in 2017. (MLPs are partnerships traded on major U.S. securities exchanges.) We believe an eventual ramp up in crude and natural gas volumes should lead to production recovery, drive strong operating leverage and increase cash flow. Ultimately, however, the performance of this sector will likely be driven by the direction of oil prices. If oil prices retreat toward $40 per barrel, energy MLPs will underperform. Rising interest rates could also be a headwind. Potential tax reform could have an impact but the likelihood of significant tax reform getting passed has diminished.

Hedge Funds have a slightly different wrinkle compared to REITs or MLPs. Hedge Funds are investment vehicles that are representative of manager skill in executing strategies in either a publicly traded or privately traded arena. There are a broad array of Hedge Fund strategies, ranging from non-leveraged to highly leveraged (investing with borrowed money). We prefer strategies that provide some protection to declining markets or behave differently than the rest of the portfolio.

Given that the Federal Reserve will likely continue raising the current policy rate for a while and that equities are trading close to historical valuation peaks, the prospect of lower returns and higher correlations between asset classes has left many investors wanting sources of return that are not tied to traditional stock and bond performances. That spells “alternatives.” And while the returns on alternative investments have not met expectations over the last several years, we believe they can still play a key role in managing risk in a fully diversified portfolio.

TAKEAWAYS:

By introducing investments that behave differently from the rest of the portfolio, investors can reduce volatility in their portfolios and potentially enhance long-term results.

Because of the complexities involved with alternative investments, potential investors should consult their investment and tax advisors when evaluating these types of investments, especially MLPs.


Disclosures:

Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of August 3, 2017. This summary is intended to provide general information only and is reflective of the opinions of Commerce Trust Company.

This material is not a recommendation of any particular security, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional. Diversification does not guarantee a profit or protect against all risk.

Commerce does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation.

Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Commerce Trust Company is a division of Commerce Bank.

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ABOUT THE AUTHOR

Cindy Rapponotti
Cindy Rapponotti, CFA®, CAIA® Senior Vice President, Portfolio Manager Commerce Trust Company
Cindy is a senior portfolio manager and chair of the Alternative Investments Strategy Committee for Commerce Trust Company. Upon gaining a thorough understanding of a client’s needs and goals as well as assessing the client’s entire financial situation, she works with our investment research team to construct a portfolio to help clients achieve their long- term goals. Cindy comprehensively represents our research- and goals-based investment process, starting with the initial assessment and creation of an investment objective to ongoing evaluation and adjustments based on changing market and life circumstances. With a deep knowledge of the market and experience in investment management, she serves clients with thought leadership, insight, and consulting services. Cindy has more than 30 years of experience in portfolio management and financial analysis. Prior to joining Commerce in 1991, Cindy worked for Chemical Bank, now J.P. Morgan Chase, in New York, and Continental Bank, now Bank of America, in Chicago. Cindy received her bachelor of arts degree from Loyola University in Chicago and her master of business administration degree from University of Chicago. She is a Chartered Financial Analyst®, a member of the CFA Institute, a member of the CFA Society of St. Louis and has received the Chartered Alternative Investment Association® charter. Cindy is a Chartered Alternative Investment Analyst® and is a member of the CAIA Association. She is a graduate of the Focus St. Louis (CORO) Women in Leadership program. Cindy serves on the board of the Clayton Century Foundation and chairs the Investment Committee of the Center of Creative Arts (COCA). She is active with the Greater St. Louis Boy Scouts Council.
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